Question

Cortex plc. is analyzing a capital budgeting project. One of the important aspects is to address the risk issues in capital budgeting. Cortex plc. management is confused between ‘scenario analysis’ and ‘sensitivity analysis’ as possible options to address the risk issues in their capital budgeting. Explain the meaning of these two approaches. Which of the two approaches would you suggest the company employ if general market conditions are expected to remain relatively stable during the project’s life?

Answer 1

Scenario analysis is the process of calculating the value of a specific investment,or a certain group of investments,under a variety of scenarios that is future possibilities.In other words,we estimate expected cash flows and asset value under various scenarios,with the intent of getting better sense and of the effect of risk on value.

Sensitivity analysis determines how different values of an independent variable affect a particular dependent variable under a given set of assumptions.In other words,Senitivity analysis is the study of how the outcome of a decision changes due to variations in inputs.

In the question,it is given that general market conditions are expected to remain relatively stable during the project’s life,hence company should employ sensitivity analysis.