As a financial analyst at Glencolin International (GI) you have been asked to revisit your analysis of the two capital investment alternatives submitted by the production department of the firm. (Detailed discussion of these alternatives is in the Mini Case) The CFO is concerned that the analysis to date has not really addressed the risk in this project. Your task is to employ scenario and sensitivity analysis to explore how your original recommendation might change when subjected to a number of "what-ifs.
In your discussions with the CFO, the CIO and the head of the production department, you have pinpointed two key inputs to the capital budgeting decision: initial software development costs and expected savings in production costs (before tax). By properly designing the contract for software development, you are confident that initial software costs for each alternative can be kept in a range of plus or minus 15 percent of the original estimates. Savings in production costs are less certain because the software will involve new technology that has not been implemented before. An appropriate range for these costs is plus or minus 40 percent of the original estimates.
As the capital budgeting analyst, you are required to answer the following in your memo to the CFO:
1. Conduct sensitivity analysis to determine which of the two inputs has a greater input on the choice between the two projects.
2. Conduct scenario analysis to assess the risks of each alternative in turn. What are your conclusions?
3. Explain what your sensitivity and scenario analyses tell you about your original