Probability Assignment:
Sensitivity analysis is superior to the single future forecast as it gives a more precise idea regarding the variability of the returns. But it has a limitation in that it does not disclose the chances of the occurrence of these variations.
To remedy this shortcoming of sensitivity analysis so as to provide a more accurate forecast, what s needed is that, to assign probability of the variations occurring in ail the outcomes. The quantification of variability of returns involves following steps:
(i) Depending on the chance of occurrence of a particular outcome, probabilities are assigned to each cash flow estimate of that particular outcome.
(ii) Cash flow estimates of all outcomes are multiplied by their assigned probabilities and added, which gives expected monetary value (EMV) for that particular period.
(iii) EMV for each period will be calculated and will be deemed as cash flow for applying various techniques of capital budgeting.
It is to be noted here that the discount rate should be risk-free. When we use probability information for calculating the expected NPV for a project, we are making explicit adjustment for the risk. Thus, if the discount rate includes premium for risk, it would result in double counting for risk.