But repeated use and an after the fact review of

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Unformatted text preview: y seem a bit imprecise to one who has not used them. But repeated use and an “after-the-fact” review of previous analyses improve the accuracy of the users. By repeating this process perhaps a thousand times, managers can create a probability distribution of net present values. Although only gross cash inflows and cash outflows are simulated in Figure 10.1, more sophisticated simulations using individual inflow and outflow components, such as sales volume, sale price, raw material cost, labor cost, maintenance expense, and so on, are quite common. From the distribution of returns, the decision maker can determine not only the expected value of the return but also the probability of achieving or surpassing a given return. The use of computers has made the simulation approach feasible. The output of simulation provides an excellent basis for decision making, because it enables the decision maker to view a continuum of risk–return tradeoffs rather than a single-point estimate. Review Questions 10–2 Define risk in terms of the cash inflows from a capital budgeting project. How can determination of the breakeven cash inflow be used to gauge project risk? 10–3 Describe how each of the following behavioral approaches can be used to deal with project risk: (a) sensitivity analysis, (b) scenario analysis, and (c) simulation. 432 PART 3 LG3 Long-Term Investment Decisions 10.3 International Risk Considerations exchange rate risk The danger that an unexpected change in the exchange rate between the dollar and the currency in which a project’s cash flows are denominated will reduce the market value of that project’s cash flow. transfer prices Prices that subsidiaries charge each other for the goods and services traded between them. Although the basic techniques of capital budgeting are the same for multinational companies (MNCs) as for purely domestic firms, firms that operate in several countries face risks that are unique to the international arena. Two types of risk are...
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