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.

Answer 1

Sensitivity analysis:

Sensitivity analysis is a technique used to identify the effect of change in given input variable on the NPV or IRR of the project, holding all other input variables constant.

Following are the assumptions used in sensitivity analysis:

1. All input variables are constant except the one that we are changing.
2. All input variables are independent. Sensitivity analysis assumes that input variables are not related to each other. Therefore, one input variable can be changed by keeping other input variables constant.
3. Probability of each variation in the given input variable is ignored.

Scenario analysis:

Scenario analysis is the technique used to determine NPV or IRR of the project under different possible alternatives or scenarios along with their probabilities. More than one input variables can be changed and their combined effect can be analyzed.

Following are the assumptions used in scenario analysis:

1. Multiple input variables can be changed.
2. Each scenario is independent.
3. Probability can be assigned to each scenario.

How options to expand or abandon a project are integrated in the capital budgeting process?

Capital budgeting is the process to evaluate the feasibility of the potential future investments.

Option to expand a project:

Some projects may have negative NPV, but still the project is accepted. This is because accepting the project will increase profitability of the business significantly in future. Following are some of the examples of such projects:

• Research and development projects
• Entry to new market
• Advertising
• Acquisition of land for expansion in future
• Acquiring rights of making a particular product

Option to abandon a project:

An existing project is abandoned to avoid heavy losses in future or the profits from the project do not appear to be significant. A project is abandoned if value that can be recovered by selling the project is more than present value of the project if it is continued. Following are some of the examples of such projects:

• Future extraction of the resources from mines is expected to be low
• Patronage of a particular airline route is reducing and is not expected to increase in future