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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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