Definition: The Scenario Analysis is a method applied to determine the feasibility of the project in terms of the change in the underlying variables simultaneously. Simply, analyzing the change in multiple variables at a time and assessing their impact on the viability of the project as a whole, is called as scenario analysis.
In scenario analysis, not only the sensitivity of NPV is evaluated in terms of the change in the underlying variables, but also, the probabilities are assigned to each variable on the basis of risk inherent in each. Such as, the probability distribution of sales determines the risk inherent in the sales.
Firstly, the base case scenario is formed by calculating the value of NPV on the basis of variable assumptions that are considered to be the most accurate. From there, other scenarios are formed called as a best case and worst case scenarios. The probabilities are assigned to each scenario on the basis of inherent risk and then the computation is done accordingly.
Once all the scenarios are listed on an excel sheet along with their probabilities, the firm compares the expected return to the expected risk for each scenario against the firm’s risk tolerance level. Once the comparison is done, the firm makes a decision in regards to whether the proposed project is to be undertaken or shall be dropped.
The scenario analysis is better than the sensitivity analysis in the sense that it considers the simultaneous change in the variables despite a change in the single variable at a time.
But however, it is based on the assumption, that there are few well-delineated (definite) scenarios, which may not be true in many cases. Such as, an economy does not necessarily lie in three states, Viz boom, recession, stability, it can lie between the extremes as well. And If the economy is analyzed in the perspective of these three distinct scenarios, some information would be lost.