fm12 23 - have the greatest impact on profitability and...

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Mini Case: 12 - 23 j. 3. What is the primary weakness of sensitivity analysis? What is its primary usefulness? Answer: The two primary disadvantages of sensitivity analysis are (1) that it does not reflect the effects of diversification and (2) that it does not incorporate any information about the possible magnitudes of the forecast errors. Thus, a sensitivity analysis might indicate that a project’s NPV is highly sensitive to the sales forecast, hence that the project is quite risky, but if the project’s sales, hence its revenues, are fixed by a long- term contract, then sales variations may actually contribute little to the project’s risk. It also ignores any relationships between variables, such as unit sales and sales price. Therefore, in many situations, sensitivity analysis is not a particularly good indicator of risk. However, sensitivity analysis does identify those variables which potentially
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Unformatted text preview: have the greatest impact on profitability, and this helps management focus its attention on those variables that are probably most important. k. Assume that Sidney Johnson is confident of her estimates of all the variables that affect the project’s cash flows except unit sales and sales price: if product acceptance is poor, unit sales would be only 900 units a year and the unit price would only be $160; a strong consumer response would produce sales of 1,600 units and a unit price of $240. Sidney believes that there is a 25 percent chance of poor acceptance, a 25 percent chance of excellent acceptance, and a 50 percent chance of average acceptance (the base case). k. 1. What is scenario analysis? Answer: Scenario analysis examines several possible situations, usually worst case, most likely case, and best case. It provides a range of possible outcomes....
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