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Scenario analysis can be used in a variety of instances with the main goal of predicting
the likely outcome of an event. People then use this prediction to make more informed
choices in the present, though there is always the risk that the prediction won't come to
fruition. This type of analysis is frequently used as a way to anticipate the value of an
investment.
Example
Ferndale Inc. is analyzing a capital budgeting expansion project with the following cash flow
forecasts:
3 year project
Unit sales = 1500 per year
Price = $50
Variable cost = $20 per unit
Fixed cost = $5000 per year
FCIn = $60000
Depreciated straight line over three years to book value of zero
NWCInv = $15000
Salvage value at the end of three years = $10000
Marginal tax rate = 40%
Cost of capital = 15%
A scenario analysis for the Ferndale capital budgeting is shown above. Notice that in the worst
case scenario unit sales, price, and salvage value are down 20% while fixed and variable cost are
up 20%. In best case scenario unit sales, price, and salvage value are up 20%, while costs are
down 20%.
Worst case
Base case
Best case
Unit sales
Down 20%
1500
Up 20%
Price
Down 20%
$50
Up 20%
Variable cost
Up 20%
$20
Down 20%
Fixed cost
Up 20%
$5000
Down 20%
Salvage value
Down 20%
$10000
Up 20%
Base case
Sales = 1500 x 50 = $75,000
Cost = Fixed + Variable = 5000 + 20 (1500) = $35,000
Depreciation = FCIn / # of years = 60000/3 = 20,000 per year
= (75,000)
= 27,826
= 24,196.6
= 21,040.5
= 13,807.8
Base NPV
= 11,871
Worst case
Unit sales
Price
Variable cost
Fixed cost
Salvage value
Base case
1500
50
20
5000
10000
= (75000)
= 13,843.5
= 12,037.9
= 10,467.66
= 13,018.82
Worst NPV
= (25,632.12)
Best case
Unit sales
Price
Variable cost
Fixed cost
Salvage value
Base case
1500
50
20
5000
10000
= (75,000)
= 46,191.30
= 40,166.35
= 34,927.26
= 14,596.86
Best NPV
= 60,882