It is important to keep in mind that when a company analyzes a potential project, it is forecasting potential not actual cash flows for a project. As we all know, forecasts are based on assumptions that may be incorrect. It is therefore important for a company to perform a sensitivity analysis on its assumptions to get a better sense of the overall risk of the project the company is about to take.

There are three risk-analysis techniques that should be known for the exam:

1. Sensitivity Analysis
Sensitivity analysis is simply the method for determining how sensitive our NPV analysis is to changes in our variable assumptions. To begin a sensitivity analysis, we must first come up with a base-case scenario. This is typically the NPV using assumptions we believe are most accurate. From there, we can change various assumptions we had initially made based on other potential assumptions. NPV is then recalculated, and the sensitivity of the NPV based on the change in assumptions is determined. Depending on our confidence in our assumptions, we can determine how potentially risky a project can be.

2. Scenario Analysis
Scenario analysis takes sensitivity analysis a step further. Rather than just looking at the sensitivity of our NPV analysis to changes in our variable assumptions, scenario analysis also looks at the probability distribution of the variables. Like sensitivity analysis, scenario analysis starts with the construction of a base case scenario. From there, other scenarios are considered, known as the "best-case scenario" and the "worst-case scenario". Probabilities are assigned to the scenarios and computed to arrive at an expected value. Given its simplicity, scenario analysis is one the most frequently used risk-analysis techniques.

3. Monte Carlo Simulation
Monte Carlo simulation is considered to be the "best" method of sensitivity analysis. It comes up with infinite calculations (expected values) given a number of constraints. Constraints are added and the system generates random variables of inputs. From there, NPV is calculated. Rather than generating just a few iterations, the simulation repeats the process numerous times. From the numerous results, the expected value is then calculated.



Security Market Line and Beta Basics

Related Articles
  1. Investing

    Scenario Analysis Provides Glimpse Of Portfolio Potential

    This statistical method estimates how far a stock might fall in a worst-case scenario.
  2. Investing

    Explaining the Monte Carlo Simulation

    Monte Carlo simulation is an analysis done by running a number of different variables through a model in order to determine the different outcomes.
  3. Investing

    Multivariate Models: The Monte Carlo Analysis

    This decision-making tool integrates the idea that every decision has an impact on overall risk.
  4. Investing

    What's a Sensitivity Analysis?

    Sensitivity analysis is used in financial modeling to determine how one variable (the target variable) may be affected by changes in another variable (the input variable).
  5. Investing

    Explaining Expected Return

    The expected return is a tool used to determine whether or not an investment has a positive or negative average net outcome.
  6. Retirement

    The 3 Best Retirement Calculators For 2016

    Find out the top three online retirement calculators to use in 2016 for determining how much you need to save to provide for sustainable income.
  7. Investing

    Create a Monte Carlo Simulation Using Excel

    How to apply the Monte Carlo Simulation principles to a game of dice using Microsoft Excel.
  8. Investing

    Why Your Investment Growth Calculator May Be Wrong

    Many simple investment growth calculators fall short, so here's one you should use instead.
  9. Investing

    Bet Smarter With The Monte Carlo Simulation

    This technique can reduce uncertainty in estimating future outcomes.
  10. Investing

    Monte Carlo Simulation With GBM

    Learn to predict future events through a series of random trials.
Frequently Asked Questions
  1. What is the difference between yield and return?

    While both terms are often used to describe the performance of an investment, yield and return are not one and the same ...
  2. What are the Differences Among a Real Estate Agent, a broker and a Realtor?

    Learn how agents, realtors, and brokers are often considered the same, but in reality, these real estate positions have different ...
  3. What is the difference between amortization and depreciation?

    Because very few assets last forever, one of the main principles of accrual accounting requires that an asset's cost be proportionally ...
  4. Which is better, a fixed or variable rate loan?

    A variable interest rate loan is a loan in which the interest rate charged on the outstanding balance varies as market interest ...
Trading Center