Assessing Investment Risks: Weighing Potential Benefits vs Liabilities - Essay Sample

Introduction

Every decision made in investment relies on a set of inputs and assumptions, which makes investment risk to be unavoidable. Therefore, an assessment needs to get carried out before the project begins to weigh the potential benefits expected against the magnitude of risks likely to occur. Every investment contains different possible outcomes of the cash flows. In most instances, the actual cash flows produced never equals the expected cash flows used in the estimation of the investment's net present value (Titman et al., 2018). The investment's cash flow and performance are determined by the value drivers, which include unit price, market share, and costs. Various tools are involved in measuring and estimating the mentioned uncertainties. The forces that determine the success or failure of business get evaluated individually using sensitivity analysis. In contrast, scenario analysis examines the effect of changing one driver at a time, while simulation analysis assesses the result of changing all drivers at the same time.

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Sensitivity analysis evaluates the effect that individual driver has on the net present value of the investment. The method is essential when trying to identify the critical value drivers likely to affect a particular investment. It also assesses how risky a strategy is and predicts the outcome of a decision in case a specific situation turns out differently compared to the key predictions.

Scenario analysis, on the other hand, examines the effects that arise from changing one given variable or driver at a time on the net present value of the investment. The method studies how the outcome of a decision changes as a result of variations in input and analyzes events in the future by putting into consideration the alternative outcomes. It involves the use of different scenarios with different sets of estimates for the investment value drivers.

For example, if I invent a new hair product that serves both as a conditioner and treatment, I can use both sensitive and scenario analysis to determine the potential benefits of releasing the product into the market. The sensitive analysis will help determine how the quantity of the product sold can be affected by a variation in price. On the other hand, scenario analysis will examine and predict how different factors will affect the sale of the product other than the price. For instance, a similar product getting released into the market first, or predict if the product will be effective as the other hair conditioners and treatment in the market.

Lastly, simulation analysis is used to assess the result of changing value drivers, all of them at the same time. Thousands of net present value estimates get generated. The values further get built on a large number of benefits for each of the investment's value drivers (Titman et al., 2018). The different values result from each value driver's probability distribution. It explores the impact of various conditions in the market on investment. It further predicts how a change in existing variables affects the future value of the investment, which helps business owners and practitioners discover new ways to improve their businesses. For example, creating different scenarios or outcomes helps companies minimize risks associated with change by applying necessary measures. Engineers and designers also use simulation to establish under what conditions change in structures might occur.

Conclusion

In conclusion, sensitivity analysis involves analyzing the effects of changing only one driver at a time on the investment's net present value. In contrast, scenario analysis provides a discrete number of the investment's net present value estimates for a finite number of scenarios or cases, while simulation analysis, on the other hand, and involves infinite scenarios to obtain possible probabilities and outcomes.

Reference

Titman, S., Keown, A. J., & Martin, J. D. (2018). Financial management: Principles and applications. New York, NY: Pearson.