What is a capital budget
A list of planned investment projects a firm is considering
What are common challenges in capital budgeting
- biased forecasts
- conflicts between departments
- inconsistent estimates
Why can’t we blindly trust NPV
Because it is based on estimates and uncertain future cash flows
What is forecasting risk
The risk that cash flow estimates are wrong
What does it mean if NPV is very sensitive to inputs
High risk - the project depends heavily on assumptions
What are “sources of value” in a project
The reasons why the project creates value (higher sales, lower costs…)
What is a scenario analysis
Analyzing how NPV changes under different overall situations
What are the 3 main scenarios
- best case
- base case
- worst case
worst and best are not necessarily probable, but can still be possible. can only see if things go really bad or really good, doesn’t give much info by itself
Purpose of scenario analysis
To see the range of possible outcomes (good vs bad)
Limitation of scenario analysis
Doesn’t show probabilities or detailed impacts of individual variables
What is sensitivity analysis
Changing one variable at a time to see its effect on NPV
The ____ the volatility in NPV in relation to a variable, the ____ the forecasting risk associated with that variable
greater ; volatility
larger ; forecasting
Key difference: sensitivity vs scenario analysis
Sen - one variable changes
Sce - many variables change together
What does high sensitivity to a variable mean
That variable is very important and risky
Why is sensitivity analysis useful
Helps identify the most critical variables
What are typical variables tested in sensitivity analysis
- sales
- price
- costs (vc, fc)
- initial investment
What is a key limitation of sensitivity analysis
It ignores that variables may be related to one another
What is simulation analysis
Running many possible scenarios using probability distributions. An expanded sensitivity and scenario analysis
What does simulation analysis produce
A distribution of possible NPVs and probability of positive NPV
What is Monte Carlo simulation
A type of simulation that runs thousands of random scenarios
Advantage of Monte Carlo simulation
Considers interactions between variables
Main limitation of simulation
Results depend heavily on the quality of input assumptions
After sensitivity analysis, what should firms do
Focus on the most critical variables and gather better data
