Scenario Analysis
Inscenarioanalysis,weestimatecashflowsunderdifferent
scenarios,rangingfromoptimistictopessimistic,andreport
theresultingconclusionsasarangeofvaluesratherthanasa
single estimate. In general, scenario analysis requires the
following steps:
- Identifying the scenarios. The first and perhaps most
criticalstepinscenarioanalysisisdeterminingthescenarios.
Initsmostnaiveformthiscantaketheformofbest-caseand
worst-casescenarios,butin moresophisticatedanalysisthe
scenarios can be built around either macroeconomic or
competitivefactors.We canvaluean automotive company
understrongandweakeconomyscenariosandabankunder
high and low interest rate scenarios.
2.Estimatingthecashflowsandvalueundereachscenario.
While thetemptationatthefirst stageoftheprocess isto
createasmanyscenariosaswecan,thesecondstageofthe
processactsasanaturalcheckonthefirststage.Wehaveto
estimate theexpectedcash flowsunder each scenario,and
needtopossessenoughinformationtomaketheseestimates.
Presumably,thevalueswillbeverydifferentunderdifferent
scenarios; if they were not, the process would be pointless.
3.Estimatingthelikelihoodofeachscenario.Coupledwith
having different scenarios must be probabilities of each
scenario occurring. Without this information, a decision
maker has no way of weighing the different estimates of
value.