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# A 10 cost of capital and a 15 year life for the

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Unformatted text preview: culated by using the corresponding annual cash inflows. A 10% cost of capital and a 15-year life for the annual cash inflows were used. scenario analysis A behavioral approach that evaluates the impact on the firm’s return of simultaneous changes in a number of variables. Scenario analysis is a behavioral approach similar to sensitivity analysis but broader in scope. It evaluates the impact on the firm’s return of simultaneous changes in a number of variables, such as cash inflows, cash outflows, and the cost of capital. For example, the firm could evaluate the impact of both high inflation (scenario 1) and low inflation (scenario 2) on a project’s NPV. Each scenario will affect the firm’s cash inflows, cash outflows, and cost of capital, thereby resulting in different levels of NPV. The decision maker can use these NPV estimates to assess the risk involved with respect to the level of inflation. The widespread availability of computers and spreadsheets has greatly enhanced the use of both scenario and sensitivity analysis. Simulation simulation A statistics-based behavioral approach that applies predetermined probability distributions and random numbers to estimate risky outcomes. Simulation is a statistics-based behavioral approach that applies predetermined probability distributions and random numbers to estimate risky outcomes. By tying the various cash flow components together in a mathematical model and repeating the process numerous times, the financial manager can develop a probability distribution of project returns. Figure 10.1 presents a flowchart of the simulation of the net present value of a project. The process of generating random numbers and using the probability distributions for cash inflows and cash outflows enables the financial manager to determine values for each of these variables. Substituting these values into the mathematical model results in an NPV. CHAPTER 10 FIGURE 10.1 Risk and Refinements in Capital Budgeting 431 Repeat NPV Simulation Flowchart of a net present value simulation Generate Random Number Probability Probability Generate Random Number Cash Inflows Cash Outflows Mathematical Model Probability NPV = Present Value of Cash Inflows – Present Value of Cash Outflows Net Present Value (NPV) Hint These behavioral approaches ma...
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