EBK CFIN
EBK CFIN
5th Edition
ISBN: 9781305888036
Author: BESLEY
Publisher: CENGAGE LEARNING - CONSIGNMENT
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Chapter 10, Problem 18PROB
Summary Introduction

Scenario Analysis is a technique used to identify the project’s risk and compare the bad and good circumstances with the base case scenario. It considers both the 1) sensitivity of the project’s NPV to its key variables and 2) the change in values of these variables considering their probability distribution.

To carry out the scenario analysis, it is required to calculate the NPV of worst case, best case and base case, followed by the calculation of its standard deviation and co-efficient of variation. If the co-efficient of variation is higher than the average project of the company, the project should be rejected.

Expected NPV, Standard deviation of NPVs and co-efficient of variation of NPVs are calculated as below:

Expected NPV=i=1nPri(NPVi)               σNPV=i=1nPri(NPViExpected NPV)2  CVNPV=σNPVExpected NPV

Here,

Probabilities of the occurrence is “Pri

NPV for each probability is “NPVi

Standard deviation of NPVs is “σNPV

Co-efficient of Variation of NPVs is “CVNPV

After conducting a scenario analysis, it is estimated, that the NPV of the project for all the three scenarios is as follows. Determine whether the project should be accepted or rejected if the maximum allowable co-efficient of variation is 0.7.

Scenario Probability NPV
Best Case 25% $185,400
Base Case 60% $128,300
Worst Case 15% -$77,600

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