Scenario Analysis

The basic form of what-if analysis is called scenario analysis. What we do is investigate the changes in our NPV estimates that result from asking questions like, What if unit sales realistically should be projected at 5,500 units instead of 6,000?

Once we start looking at alternative scenarios, we might find that most of the plausible ones result in positive NPVs. In this case, we have some confidence in proceeding with the project. If a substantial percentage of the scenarios look bad, then the degree of forecasting risk is high and further investigation is in order.

There are a number of possible scenarios we can consider. A good place to start is with the worst-case scenario. This will tell us the minimum NPV of the project. If this turns out to be positive, we will be in good shape. While we are at it, we will go ahead and determine the other extreme, the best case. This puts an upper bound on our NPV.

To get the worst case, we assign the least favorable value to each item. This means low values for items like units sold and price per unit and high values for costs. We do the reverse for the best case. For our project, these values would be:

scenario analysis

The determination of what happens to NPV estimates when we ask what-if questions.

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