Question

1. Review the types of assumptions used in sensitivity and scenario analysis. Describe how the options to expand or abandon a project are integrated in the capital budgeting process. Explain how decision trees are used to value investment alternatives.

Answer 1

The assumptions that are used in case of sensitivity and scenario analysis are used for the purpose of making the sensitivity models workable. The assumptions ensures that the models will able to throw light on how different values of a set of independent variables affect a specific dependent variable under specific conditions. The specific conditions are the assumptions and without these assumptions the sensitivity models may go awry. For instance when developing a sensitivity model for income statement and balance sheet if we assume that the company is operating 10% below capacity and sales will grow by 10% next year then the in the next year’s balance sheet the assets will remain unchanged. This is because as the company is operating below capacity further assets will not be needed to support the sales growth of 10%.

The options to expand or abandon a project are integrated in the capital budgeting process through real options valuation. In other words option valuation techniques are applied to capital budgeting decisions. A real option is the right (and not an obligation) to do certain business activities or undertake certain business initiatives. The option to expand is often embedded in investment projects and the feasibility of either expanding or abandoning a project is determined by making use of incremental capital budgeting tools like doing an incremental NPV analysis.

Decision trees are used to value investment alternatives through forecasting of future outcomes and then assigning probabilities to events related to investment alternatives. Potential outcomes related to investment alternatives are contingent on prior events and becomes dynamic with complex decisions. Decision tree is used to assign probabilities and then forecast the net benefits/losses associated with different scenarios and economic conditions. These numbers will help in more accurate determination of values of investment alternatives.