Scenario analysis

Scenario analysis A scenario analysis is a special case of an analysis where a pre-determined set of possible outcomes are identified. The pre-determined case scenarios are usually labeled according to their expected value from best to worst. These scenarios are identified by managers as likely outcomes based on previous personal experience, industry statistics, or historical performance of similar projects in a company.

A scenario analysis is used in conjunction with a financial model and the output of each scenario is calculated. The output is tied to the set of assumptions that defines each scenario based on market conditions and company performance. The assumptions for each scenario are defined and the value of the project is calculated using a financial model. The outcome of the scenario analysis will be a range of project values derived from each set of assumptions.

For example, in investment and finance, an enterprise might attempt to forecast several possible scenarios for the market (e.g. rapid growth, moderate growth, slow growth) and it might also attempt to forecast returns from a future investment (for NPV) in each of those scenarios. It might consider sub-sets of each of the possibilities. A different NPV calculation can then be made for each different scenario. For example, suppose an organisation is considering investing in the following project: capital outlay 50000 euro, current interest rate 15% and expected returns of 20000 euro in the three years of the project's life. Using this information the calculated NPV is positive the investment is acceptable based on the criteria for NPV, (NPV>0). Suppose that some decisionmakers are more pessimistic about the future and estimate that the expected returns for the next three years are 20000, -17500 and -17500. If all other factors remain constant then the calculated NPV is negative. The project would therefore, be rejected.

Scenario analyses are highly effective as a communication tool to describe the uncertainty of a project. Managers usually present a range of likely outcomes from worst to best providing visibility as to the “things” that can happen during the implementation of a project. The scenario analysis bounds the outcomes of a project and communicates the risks associated with the project.

Depending on the complexity of the investment environment, in investment scenario analysis can be a demanding exercise. It can be difficult to foresee what the future holds (e.g. the actual future outcome may be entirely unexpected), i.e. to foresee what the scenarios are, and to assign probabilities to them; and this is true of the general forecasts never mind the implied project returns. The outcomes can be modelled mathematically/statistically e.g. taking account of possible variability within single scenarios as well as possible relationships between scenarios.

One aspect of this approach is that prediction and risks are subjective: The marketing department may be optimistic and the production department pessimistic.

Secondly, we have related optimistic/pessimistic scenarios only to the expected returns. Should we also not consider these same scenarios in relation to some variable, for example, the interest rate?

Third, scenario analysis provides no rules to guide the decision-maker as to whether the initial appraisal advice should or should not be amended in the light of the sensitivity data.

Finally, based on the outcome of the scenario analysis, a Sensitivity analysis along with a Monte Carlo simulation can be completed to fully understand the dynamics of the underlying variables. These analyses will add further understanding to identify the critical success factors of a project.