Note the irony of scenario 1: our workers are too sick to make the medicine.
To find 3.16987, use your financial calculator to find the PV of an annuity that pays $1 per period for 4 periods when the discount rate is 10%.
Capital budgeting in uncertainty
Sensitivity Analysis, Scenario
Analysis, and Break-Even Analysis
us to look behind the NPV
number to see how firm our estimates
When working with spreadsheets, try to
build your model so that you can just
adjust variables in a few cells and have
the NPV calculations respond to that
Sensitivity Analysis: Baldwin Company
can see that NPV is very sensitive to
changes in price
In the Baldwin Company example, a 10%
drop in price leads to a 82% drop in NPV
For every 1% drop in price we can expect
roughly a 8.2% drop in NPV
Scenario Analysis: Baldwin Company
A variation on sensitivity analysis is scenario
For example, the following three scenarios could
apply to Baldwin Company:
In the next years bowling becomes very popular
because of a blockbuster movie showing it as a cool
and hip pastime for young people.
The next years are normal and sales meet
The next years see a 3 D computer graphics
breakthrough introducing a virtual form of bowling that
begins to compete with the physical version.
For each scenario, calculate the NPV.
Break-Even Analysis: Baldwin Company
way to examine variability in our
forecasts is break-even analysis
In the Stewart Pharmaceuticals example, we
could be concerned with break-even sales
volume or break-even price
To find either, we need to find the level of
sales volume or price at which NPV
Monte Carlo Simulation
Carlo simulation is a further attempt to
model real-world uncertainty
Monte Carlo simulation of capital budgeting
projects is often viewed as a step beyond
either sensitivity analysis or scenario
Replace deterministic point estimates with
probabilistic range estimates
Monte Carlo Simulation (contd.)
large number of iterations
For each iteration a random number is
picked for each of the variables modeled
For each iteration, NPV is calculated
Based on all iterations, a probability
distribution of NPV is obtained
Different levels of NPV at different
confidence levels instead of a single NPV
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