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Free Example of Sensitivity and Scenario Analysis Essay

Sensitivity analysis refers to an evaluation technique that is used in business finance field to determine impact or effect of various values of an independent variable on another dependent variable. In real life situations, sensitivity analysis is used by investors to determine the effects that changes in interest rates have on their investments. Sensitivity analysis has been used in calculating the overall changes in returns on investments as a result of changes in interest rates and inflation rates.

According to Brigham and Houston, sensitivity analysis is often used in making crucial business decisions that involve variations in two or more variables, in which one variable is dependent on another (2008). In financial investments, sensitivity analysis is used to determine the optimal allocation of resources, so as to maximize returns. Sensitivity analysis has also been used for manufacturing industries to determine the ability of production techniques or systems to sustain variations of inputs, such as raw materials and labor. Mun asserts that sensitivity analysis can also be used in estimating the quantity of risks involved in investment projects (2010).

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An experimental example for sensitivity analysis is a valuation of shareholder’s equity in a firm in relation to the dividends payable at the end of a financial year. When the dividends payable are high, value of the shares would increase whereas low dividends payable would lead to decline in value of shares.

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On the other hand, scenario analysis measures combined effects of various variables in the future under different scenarios. For example, the net present value of a project may be altered to determine the possibility of success of the project under favorable and unfavorable conditions. In scenario analysis, all the variables are altered so as to determine their overall effect under different scenarios such as optimistic, most likely and pessimistic. Scenario analysis measures effects that changes have on interdependent variables and their possible outcomes. Scenario analysis helps in projecting possible future outcomes or alternatives of a given problem (Mun 2011). In scenario analysis, various outcomes and their implications are critically analyzed.

In real life situations, scenario analysis has been used in determining the best possible combination of investment portfolios under various statuses of the economy, for example, under high, poor and moderate economic growth rates. An experimental example of scenario analysis is an allocation of firm’s assets. A company may use scenario analysis to calculate various expected returns from allocation of assets and resources under different situations.

In conclusion, I would assert that sensitivity and scenario analysis are usually used in capital budgeting decisions. Sensitivity and scenario analysis have been successfully used in effective planning for the future of business organizations.

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