Principles of Managerial Finance

CHAPTER 10 Risk and Refinements in Capital Budgeting 431

By repeating this process perhaps a thousand times, managers can create a proba-

bility 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 compo-

nents, 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 deci-

sion 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 riskin terms of the cash inflows from a capital budgeting project.

How can determination of the breakeven cash inflowbe 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.

Mathematical Model

NPV = Present Value of Cash Inflows – Present Value of Cash Outflows

Probability

Cash Inflows

Repeat

Generate

Random

Number

Probability

Cash Outflows

Probability

Net Present Value (NPV)

Generate

Random

Number

FIGURE 10.1

NPV Simulation
Flowchart of a net present
value simulation

Hint These behavioral
approaches may 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.