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Scenario Analysis vs Sensitivity Analysis
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What is Scenario Analysis vs Sensitivity Analysis?
To understand scenario analysis vs sensitivity analysis, one should first understand that investment
decisions are based on a set of assumptions and inputs. The lack of certainty in the premises and inputs
brings about investment risk. Before making an investment, an individual assesses the magnitude of
such risks and weighs it against potential benefits.
Scenario Analysis vs Sensitivity Analysis
Scenario analysis is the process of predicting the future value of an investment depending on changes
that may occur to existing variables. It requires one to explore the impact of different market conditions
on the project or investment as a whole.
In contrast, sensitivity analysis is the study of how the outcome of a decision changes due to variations
in input. It is used in situations that rely on one or more input variables. For example, bond prices can be
affected by changes in inflation, interest rates, and credit ratings.
Investors use both techniques to determine the best possible investments.
Understanding Scenario Analysis vs Sensitivity Analysis
Investors use the two analytical methods to establish the amount of risk and potential benefits. The
difference between the two methods is that sensitivity analysis examines the effect of changing just one
variable at a time.
On the other hand, scenario analysis assesses the effect of changing all the input variables at the same
time. With such an approach, an analyst comes up with different possible events that are likely to occur
in the future.
Usually, scenario analysis requires the analyst or investor to create three possible scenarios:
Base-case scenario – Refers to the ordinary/typical scenario. For example, to identify the net present
value of an investment, one would likely use the discount rate and tax rate.
Worst-case scenario – Refers to the most extreme situation that can happen if things don’t go as
planned. In the earlier example, one would use the highest possible tax rate or the highest discount rate.
Best-case scenario – Refers to the most favorable projected outcome. Still using the example above, it
would entail using the lowest possible tax rate or the least possible discount rate.
Example of Scenario Analysis vs Sensitivity Analysis
The concepts of sensitivity and scenario analyses can better be understood by using an example.
Imagine that an individual has invented a composite material that can not only be used in manufacturing
mobile casings but also in charging phones. To determine the potential benefits of releasing his product
into the market, the inventor can use scenario or sensitivity analysis.
Sensitivity analysis can help him determine how sensitive the dependent variable is (the quantity of
composite material sold) if there’s a variation in the independent variable (the casing composite price).
As mentioned earlier, the sensitivity analysis model examines to what extent the outcome will change
based on changes made to a single variable. However, one can also consider other factors apart from
the outcome. For example, is the composite material compatible with the cases that are currently in the
market?
In summary, sensitivity analysis is a prediction of how a specific percentage increase in price will lead to
a subsequent percentage decrease in the quantity of products sold.
On the other hand, scenario analysis entails making several premises about different independent
variables and then examining how the outcome changes. In the example above, the inventor would
examine how other factors (other than price) would affect the sales of his revolutionary mobile case
composite material.
What if there’s another company working on a similar technology, and it manages to release its product
into the market first? What if the material makes the phone bulky? Will it still be as attractive as the
current mobile cases?
Advantages of Sensitivity Analysis
1. Provides an in-depth assessment
Sensitivity analysis requires that every independent and dependent variable be studied in a detailed
manner. It helps to determine the association between the variables. Even better, it facilitates more
accurate forecasting.
2. Helps in fact-checking
Sensitivity analysis helps companies determine the likelihood of success/failure of given variables. Let’s
say a company is looking for ways to increase the sales of its product. Sensitivity analysis can help them
discover that a more refined packaging boosts their sales by a certain margin.
Advantages of Scenario Analysis
The beauty of using scenario analysis is that it doesn’t emphasize on accurately predicting the outcome.
Instead, it generates several possible future events that are valid, although uncertain. There’s no
question that companies benefit significantly from such an approach.
1. Improves systems thinking
Think of scenario analysis as chess where players think of multiple possible moves that will increase their
likelihood of winning the game. In the case of a company, a manager can predict the likely positive and
negative outcomes that will result from implementing certain policies and strategies.
2. Leads to an optimal allocation of resources
Since scenario analysis involves forecasting future events, it helps company owners to be aware of the
external conditions that are likely to affect their operations. This, in turn, helps them to allocate
resources more effectively in order to avoid negative consequences that may arise.
Summary
Sensitivity analysis is the process of tweaking just one input and investigating how it affects the overall
model.
In contrast, scenario analysis requires one to list the whole set of variables and then change the value of
each input for different scenarios. For example, the best-case scenario can help one predict the
outcome when there’s a decrease in interest rates, an increase in the number of customers, and
favorable exchange rates.
More Resources
Thank you for reading CFI’s guide to Scenario Analysis vs Sensitivity Analysis. To keep learning and
advancing your career, the following CFI resources will be helpful:
Analysis of Financial Statements
Investing: A Beginner’s Guide
Rate of Return
Scenario & Sensitivity Analysis in Excel
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