Financial Forecasting, Analysis and Modelling: A Framework for Long-Term Forecasting

CHAPTER 7

Using Scenarios

Chapter 7 deals with scenario analysis. Scenario analysis is a strategic process of analyzing decisions by considering alternative possible outcomes. It may be used as an analytical tool to manage uncertainty. The purpose of scenario analysis is to provide a plausible idea of what might happen into the future. For example, we use scenario analysis to determine the Net Present Value (NPV) of a potential investment under high and low inflation scenarios.

By analyzing various scenarios, we are in a better position to anticipate the outcomes of our model. The examples presented in this chapter use 3 different scenarios: base case, worst case, and best case. The base case is the expected scenario: if all things proceed normally, this is what the expected outcome will be. The worst and best cases are obviously scenarios with less and more favourable conditions, but they are still confined by a sense of feasibility.

7.1 INTRODUCTION

The previous chapter introduced sensitivity analysis as a means of incorporating uncertainty and risk into financial models. Every organization faces a unique set of risks in the current rapidly changing marketplace, full of political and economic uncertainties. As financial analysts and modellers, we have to plan for whatever might go wrong and be ready to support the company's management. Identifying, analyzing, and mitigating what can go wrong can provide peace of mind and a strong competitive advantage to the companies we work ...