Sensitivity analysis: A Sensitivity analysis states about the changes in one variable may affect other variables. This technique is used to predict the changes in results due to occurrence of different situations. Firms use sensitivity analysis to determine their cash flow if there is any change in sales of the firm (Brigham and Houston, 2011).
Example: In the below table changes in price of the product affects the sales revenue of the company.
Scenario analysis: In scenario analysis the possible results of the future are identified by considering the different situations. It analyze that what will be the outcome if any worst or favorable case happens (Brigham and Houston, 2011). Firms generally used this method to calculate expected value of its investment.
Example: suppose the initial cost of firm’s project is 10000 and its life is 7 years.
Best case scenario: Cash flows at the end of 5th year are 15000.
Worst case scenario: Cash flow at end of 7th year is 15000.
Real options are those options which are based on tangible assets in which the investor has the choice that whether they should expand the project or cease the project and it is depend upon occurrence of certain conditions (Treanor, 2012).
Working of Real Option
Suppose a company invests in project, management may have an option that whether they should expand the project, abandon the project, downsize the project or there is any option for the growth in the project (Bennouna, Meredith and Marchant, 2010).
There are many real options and it may depend upon the different situation of the project. Growth option is the favorable option as this option facilitates the investor to identify the opportunity that whether the firm will get more return from the project or there are any chances of growth in future for the project (Treanor, 2012).
Treanor, D.S. (2012). The flexibility and benefits of operating a diverse fleet: an analysis using real options. Management Research Review. 35(6). pp.462 – 472.
Bennouna, K., Meredith, G. G. and Marchant, T. (2010). Improved capital budgeting decision making: evidence from Canada. Management Decision. 48(2). pp.225 – 247.
Brigham, F. E. and Houston, F. J. (2011). Fundamentals of Financial Management Concise. Cengage Learning.
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