Scenario analysis

(Question)
Which of the following best describes how a replacement project should implement scenario analysis to analyze the replacement project?

A. Generate a base case, high, and low estimate of NPV by changing only the most sensitive cash flow variable.
B. Generate a base case, high, and low estimate of NPV by changing only the discount rate applicable to the project.
C. Generate a base case, high, and low estimate of NPV by simultaneously changing sales, expense, and discount rate assumptions for each case.

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Answer: C

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In scenario analysis, the analyst simultaneously changes several key variables to generate several different scenarios. Generally, three scenarios are created: (1) worst case, (2) most likely, and (3) optimistic. For the worst case scenario, for example, the analyst will use the slowest growth in sales, highest growth in expenses, and highest discount rate to derive an NPV under the worst of all possible situations.
A similar approach is used to generate the optimistic scenario, but the best possible growth in each of the variables is used.
The most likely is simply what the analyst thinks are the most reasonable assumptions for the discounted cash flow forecast under normal conditions. Using the different cases, the analyst can assess the risk of the project.