13.5 Scenario analysis

Question 1

What is scenario analysis?

Answer 1

A method of risk assessment whereby various possible outcomes are assessed by creating various scenarios that may occur.

Question 2

How is scenarios analysis conducted?

Answer 2

New present value (NPV) is calculated for various “states of the world”, usually a “downside”, “upside” and “most likely” scenario.

Question 3

What are the key weaknesses of scenario analysis?

Answer 3

• the model becomes increasingly difficult and time consuming as the number of variables increases
• it does not consider the probability of each state of the world occurring when evaluation possible outcomes
• it does not consider other scenarios that may occur.