Question

When projects involve certain, or constant, cash flows, the capital budgeting analysis that can be conducted is very simple and straightforward. Unfortunately, this type of project rarely exists.

When a project’s cash flows, or the conditions that affect their magnitude or timing, vary from their expected values, then the analysis becomes more complicated. Projects that have the potential to exhibit greater or lesser levels of risk than the firm’s average, or normal, level means that adjustments should be made to the capital budgeting analysis process.

Several techniques are used to assess the stand-alone risk, which reflects the uncertainty about the project’s cash flows. Some of these techniques are: (1) sensitivity analysis, (2) scenario analysis, and (3) Monte Carlo simulation.

When a firm is performing a sensitivity analysis on a project, an increase in variable costs or fixed costs will generally cause the project’s net present value (NPV) to increase/decrease.

Sensetivity Analysis/Monte Carlo simulation is a risk analysis technique that uses sophisticated software to analyze a large number of scenarios and generate estimated rates of return and risk indexes.

Answer 1