Lecture 6: Advanced Topics in Capital Budgeting Flashcards
1.) Sensitivity analysis 2.) Break-even analysis 3.) Simulation analysis 4.) Decision-tree analysis
What is Sensitivity Analysis
Impact of changes in estimated variables on NPV
“What Ifs”
How do we calculate the NPV in Sensitivity Analysis
Calculated using:
- Both Optimistic & Pessimistic estimates for each variable in turn whilst other variable retain their expected values
What do we look at in Sensitivity Analysis and what must be ensured
Look at the RANGE as a measure of sensitivity of each variable
Ensure that PROBABILITIES are the same
What are the advantages of Sensitivity Analysis
- ) Alert sensitive areas that may warrant more thorough data collection
- ) Indicate sensitive areas where managements should direct more efforts when project begins
What are the disadvantages of Sensitivity Analysis
- ) Ignores inter-dependencies/correlations between variables (e.g. sales price & volume)
- ) “Optimistic” and “Pessimistic” ambigious
- ) Variables are autocorrelated over time (change in sensitivity as project goes on)
What is break-even analysis?
Examines conditions under which NPV of a project is reduced to 0 (i.e. NPV change is constant)
Colloquial sentence to describe break-even analysis
How bad can things become before the project DECREASES wealth
What are the advantages of Break-even analysis
- ) Alert sensitive areas that may warrant more thorough data collection
- ) Indicate sensitive areas where managements should direct more efforts when project begins
What are the disadvantages of Break-even analysis
- ) Ignores inter-dependencies/correlations between variables (e.g. sales price & volume)
- ) “Optimistic” and “Pessimistic” ambigious
- ) Variables are autocorrelated over time (change in sensitivity as project goes on)
What do we look at in Break-even Analysis
We look at the PROBABILITY of variable change. Because NPV Change is constant.
What is Simulation Analysis
- ) Take each variable and give a probability distribution
- ) Correlation parameters
- ) Given random values based on constraints of probability and correlation parameters
- ) Calculate NPV and generate distribution of outcomes
What are the advantages of Simulation Analysis
- ) Good for pricing options (esp. real options) where there may be non analytic solutions
- ) Allows inter-dependencies/correlations between variables
What are the disadvantages of Simulation Analysis
- ) Accept/Reject ambigious
- ) Probability distribution ambigious
- ) Focuses on total risk and ignores risk that might be removed by diversification
What is the difference between Decision-Tree Analysis and traditional NPV
NPV: ‘set and forget’ - Sequence of decisions
Decision-Tree: Sequential decision making
What are the advantages of Decision-Tree Analysis
Link’s today decision with future possible decisiona
What are the disadvantages of Decision-Tree Analysis
- ) Multiple decisions and outcomes
- ) Impossible to account for all permutations
3.) A decision tree can suggest that an option has no value because there is no point at
which it seems to be optimal for it to be exercised – whereas in reality there are
circumstances where it may be optimal to exercise the option.
Breakeven Analysis: “All they have to do is concentrate their attention on the variable for which the smallest percentage change in value will yield NPV equal to zero”. Why is this wrong
Having determined the change necessary to induce a zero net present value, managers must ask is “which change is most likely to occur?”
- Mistake to concentrate on variable that requires smallest change for NPV=0 as this change might be less likely than a larger change by another variable that also induces a zero net present value.
