10 Questions
What is the purpose of sensitivity analysis in capital budgeting?
To assess the risk of a project
What is the primary focus of risk analysis in capital budgeting?
Cash inflows
Which of the following factors does not affect the cash inflows of a project?
Initial investment
What does a lower range of NPV in sensitivity analysis indicate?
Lower risk
What is the primary difference between the two projects in the given scenario?
Different probabilities of cash inflows
Risk analysis is primarily concerned with the uncertainty of the initial investment.
False
A higher probability of cash inflows implies a lower risk.
True
Sensitivity analysis involves estimating NPV based on a single expected approach.
False
The project with a higher range of NPV in sensitivity analysis is considered less risky.
False
Cash inflows are based on factors such as sales projections, taxes, and labor rates.
True
Study Notes
Risk Analysis in Capital Budgeting
- Risk analysis refers to the chance that the selection of a project will prove to be unacceptable.
- In capital budgeting, risk analysis is primarily based on the predictability of cash inflows.
Factors Affecting Cash Inflows
- Sales projections
- Taxes
- Cost of raw materials
- Labor rates
- General economic conditions
Sensitivity Analysis
- A simple way to assess risk
- Involves estimating NPV based on different scenarios:
- Optimistic (best case) approach
- Most likely (expected) approach
- Pessimistic (worst case) approach
Project Comparison
- If two projects have the same initial investment, identical NPVs, and same yearly cash inflows to break even, but different probabilities of cash inflow occurrence, the project with the higher probability is considered less risky.
- Project A with a 95% probability of cash inflow occurrence is considered better than Project B with a 70% probability.
NPV Analysis
- Project A has a smaller range of NPV compared to Project B, implying that Project A is less risky.
- NPV analysis can be used to compare and assess the risk of different projects.
Explore the concepts of capital budgeting and risk analysis in finance. Learn how to evaluate investment projects and make informed decisions. Understand the role of probability in risk assessment and its impact on project selection.
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