Principles of Managerial Finance

Scenario analysisis a behavioral approach similar to sensitivity analysis but

broader in scope. It evaluates the impact on the firm’s return of simultaneous

changes in a number of variables,such as cash inflows, cash outflows, and the

cost of capital. For example, the firm could evaluate the impact of both high

inflation (scenario 1) and low inflation (scenario 2) on a project’s NPV. Each sce-

nario will affect the firm’s cash inflows, cash outflows, and cost of capital,

thereby resulting in different levels of NPV. The decision maker can use these

NPV estimates to assess the risk involved with respect to the level of inflation.

The widespread availability of computers and spreadsheets has greatly enhanced

the use of both scenario and sensitivity analysis.

Simulation

Simulationis a statistics-based behavioral approach that applies predetermined

probability distributions and random numbers to estimate risky outcomes. By

tying the various cash flow components together in a mathematical model and

repeating the process numerous times, the financial manager can develop a prob-

ability distribution of project returns. Figure 10.1 presents a flowchart of the sim-

ulation of the net present value of a project. The process of generating random

numbers and using the probability distributions for cash inflows and cash out-

flows enables the financial manager to determine values for each of these vari-

ables. Substituting these values into the mathematical model results in an NPV.

430 PART 3 Long-Term Investment Decisions

simulation
A statistics-based behavioral
approach that applies predeter-
mined probability distributions
and random numbers to estimate
risky outcomes.

TABLE 10.2 Sensitivity Analysis

of Treadwell’s

Projects A and B

Project A Project B

Initial investment $10,000 $10,000

Annual cash inflows

Outcome

Pessimistic $1,500 $ 0

Most likely 2,000 2,000

Optimistic 2,500 4,000

Range $1,000 $ 4,000

Net present valuesa

Outcome

Pessimistic $1,409 $10,000

Most likely 5,212 5,212

Optimistic 9,015 20,424

Range $7,606 $30,424

aThese values were calculated by using the correspond-

ing annual cash inflows. A 10% cost of capital and a

15-year life for the annual cash inflows were used.

scenario analysis
A behavioral approach that
evaluates the impact on the
firm’s return of simultaneous
changes in a number of
variables.