Lecture 6: Advanced Topics in Capital Budgeting

Question 1

What is Sensitivity Analysis

Answer 1

Impact of changes in estimated variables on NPV

“What Ifs”

Question 2

How do we calculate the NPV in Sensitivity Analysis

Answer 2

Calculated using:
- Both Optimistic & Pessimistic estimates for each variable in turn whilst other variable retain their expected values

Question 3

What do we look at in Sensitivity Analysis and what must be ensured

Answer 3

Look at the RANGE as a measure of sensitivity of each variable

Ensure that PROBABILITIES are the same

Question 4

What are the advantages of Sensitivity Analysis

Answer 4

1. ) Alert sensitive areas that may warrant more thorough data collection
2. ) Indicate sensitive areas where managements should direct more efforts when project begins

Question 5

What are the disadvantages of Sensitivity Analysis

Answer 5

1. ) Ignores inter-dependencies/correlations between variables (e.g. sales price & volume)
2. ) “Optimistic” and “Pessimistic” ambigious
3. ) Variables are autocorrelated over time (change in sensitivity as project goes on)

Question 6

What is break-even analysis?

Answer 6

Examines conditions under which NPV of a project is reduced to 0 (i.e. NPV change is constant)

Question 7

Colloquial sentence to describe break-even analysis

Answer 7

How bad can things become before the project DECREASES wealth

Question 8

What are the advantages of Break-even analysis

Answer 8

1. ) Alert sensitive areas that may warrant more thorough data collection
2. ) Indicate sensitive areas where managements should direct more efforts when project begins

Question 9

What are the disadvantages of Break-even analysis

Answer 9

1. ) Ignores inter-dependencies/correlations between variables (e.g. sales price & volume)
2. ) “Optimistic” and “Pessimistic” ambigious
3. ) Variables are autocorrelated over time (change in sensitivity as project goes on)

Question 10

What do we look at in Break-even Analysis

Answer 10

We look at the PROBABILITY of variable change. Because NPV Change is constant.

Question 11

What is Simulation Analysis

Answer 11

1. ) Take each variable and give a probability distribution
2. ) Correlation parameters
3. ) Given random values based on constraints of probability and correlation parameters
4. ) Calculate NPV and generate distribution of outcomes

Question 12

What are the advantages of Simulation Analysis

Answer 12

1. ) Good for pricing options (esp. real options) where there may be non analytic solutions
2. ) Allows inter-dependencies/correlations between variables

Question 13

What are the disadvantages of Simulation Analysis

Answer 13

1. ) Accept/Reject ambigious
2. ) Probability distribution ambigious
3. ) Focuses on total risk and ignores risk that might be removed by diversification

Question 14

What is the difference between Decision-Tree Analysis and traditional NPV

Answer 14

NPV: ‘set and forget’ - Sequence of decisions

Decision-Tree: Sequential decision making

Question 15

What are the advantages of Decision-Tree Analysis

Answer 15

Link’s today decision with future possible decisiona

Question 16

What are the disadvantages of Decision-Tree Analysis

Answer 16

1. ) Multiple decisions and outcomes
2. ) 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.

Question 17

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

Answer 17

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.