Sensitivity Analysis, Scenarios and

Monte Carlo Simulation

1

Project analysis requires considering a

number of what-if questions.

Cash-flows, costs, interest rate, inflation,
sales forecast, economic condition, labor
market, government policies, taxes &
duties etc. are all estimates.
What-if analysis helps in understanding
the implications and evaluation of risks
before committing resources to the
project.
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Sensitivity Analysis, Scenarios and

Monte Carlo Simulation
2

How NPV would be affected if you have made

wrong forecast of sales, costs, etc., as there

would always be surprises, adjustments,

refinements, and even disappointments.
Uncertainty means more things can
happen than will happen.
Sensitivity analysis, scenario analysis, and
Monte Carlo simulations are used to gain
insight considering different options and
its probability of occurrence.
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Sensitivity Analysis, Scenarios and

Monte Carlo Simulation
3

Sensitivity analysis: Analysis of the

effects on project profitability of changes

in sales, costs, and so on.
Scenario analysis: Project analysis given a
particular combination of assumptions.
Simulation analysis: Estimation of the
probabilities of different possible
outcomes, e.g., from an investment
project.
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Sensitivity Analysis, Scenarios and

Monte Carlo Simulation
4

a computerized
mathematical technique that allows
people to account for risks with a range
of possible outcomes and the
probabilities they will occur for any
choice of action.

Monte Carlo simulation:

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Sensitivity Analysis, Scenarios and

Monte Carlo Simulation
5

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Sensitivity Analysis
6

006. CF_Ch 10

Real Options
7

Managers are not dummies. Once they

have invested in a new project, they do not

sit back and watch the future unfold.
They are paid for results.
Real Option: An alternative or choice that
becomes available with a business
investment opportunity.
It is called "real" because it usually pertain
to tangible assets such as capital
equipment, rather than financial
instruments.
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Real Options
8

1. The option to expand: if the project is

successful, they may go for expansion.

2. The option to abandon: if the project is
unsuccessful, it may be abandoned.
3. The timing option: its not a now or
never. You can wait for sometime.
4. Flexible production/ operation:
Flexibility to vary output mix as demand
changes.
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Common capital budgeting pitfalls

9

1. Ensuring that forecasts are consistent:

Inconsistent assumptions often creep into

investment proposals.
2. Eliminating conflict of interest: managers
want to do a good job, but they are also
concerned about their future.
3. Reducing forecast bias: someone may
overstate cash flows to get his/ her project
accepted.
4. Sorting the wheat from chaff: Senior
managers have to look for really good project.
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