ch12-lect - Chapter 12 Risk, Capital Budgeting, and...

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Chapter 12 Risk, Capital Budgeting, and Diversification Introduction The uncertainty in forecasted cash flows for projects creates risk for firms. Sensitivity Analysis, Scenario Analysis, Breakeven Analysis and Monte Carlo Simulations are ways to analyze this risk. In this chapter we look at ways of capturing risk in our models to improve their predictive value. We’ll employ the following tools and statistical functions: Capturing Risk in Modeling Sensitivity Analysis To conduct a sensitivity analysis, hold all projections constant except one; alter that one, and see how sensitive cash flows (and NPV) are to the change – the point is to get a fix on where forecasting risk may be especially severe. You may want to use the Worst-case/Best-case idea for the item being varied. Common exercises include varying sales, variable costs, and fixed costs. Scenario Analysis Worst-case/Best-case scenarios: putting lower and upper bounds on cash flows. Common exercises include poor revenues/high costs and high revenues/low costs. Note that a thorough
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ch12-lect - Chapter 12 Risk, Capital Budgeting, and...

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