Sensitivity Analysis and Risk Incorporation in Capital Budgeting

Questions
Prepare a PowerPoint presentation on this topic. Include the following:
Title slide . 
5-7 content slides (Not including Title and Reference Slide) explaining the qualitative and quantitative steps necessary in conducting a Sensitivity Analysis. How can a project’s risk be incorporated into a Capital Budgeting analysis? Use concise bullet points on the slide and the Speaker Notes section to add details for each slide (this becomes your video “speech”).
 Minimum of 2 References.
A+ work required 
Must be plagiarism free. 

Answer
1. Introduction
In either case the evaluation is easier said than done. High risk investment opportunities are often rejected because it is difficult to quantify the risk and many different probability of success weighted cash flows could yield an unsatisfactory expected return. This is where risk incorporation in capital budgeting can provide a simple yet powerful tool to quantify risk and improve investment decisions.
It is impossible however, to predict the cash flows from investment project with perfect accuracy. Some factors are relatively certain to be correct in their expectation such as a firm’s term structure on their outstanding debt, the sensitivity of these cash flows given a particular interest rate could be measured quite precisely. A sensitivity analysis in this situation would involve a simulation to estimate the change interest rates given a time. On the other hand, if a firm is investing to launch a new product or service and have very little information about the market demand, the cash flows and expected rate of return from the opportunity are highly uncertain.
In recent years, sophisticated techniques for evaluating investment opportunities have been developed in the areas of sensitivity analysis and risk incorporation. Capital budgeting is by now a well-developed and critical organizational planning process field that helps to evaluate and select investment projects that will yield long run profits and/or cash flows that surpass a company’s cost of capital. At the heart of it, capital budgeting is a search for the rate of return, r, that will maximize the market value of a firm’s common stock. This involves analytical processes ranging from finding cost of debt or equity, to adjusting for risk in the cash flows that are being estimated from a particular investment opportunity. With the growth of computing power and information technology it has become more feasible intuitively and statistically evaluate a particular investment opportunity, incorporating modern portfolio theory and an overall trend toward higher risk investments. It is clear the importance of evaluating an investment’s risk and or return.
1.1 Purpose of the Presentation
Capital budgeting decisions are among the firm’s most critical strategic decisions because of their long term, high cost, and difficult-to-reverse nature. These characteristics make capital budgeting decisions the most likely to be erroneous of all decisions, thereby creating a significant business risk. It is for these reasons that the purpose of this presentation is to stress the importance of utilizing sensitivity analysis and risk incorporation when making capital budgeting decisions. This paper will first define and outline the importance of sensitivity analysis and risk incorporation when making capital budgeting decisions. Simulation analysis is an extension of these methods and is more complex and computationally demanding. Simulation analysis has been proven to be useful in the evaluation of projects and also is an effective method to incorporate risk. Simulation uses a model that describes the probability distributions of various input variables and generates a probability distribution for the NPV of the project. By creating a probability distribution of expected NPV, management can see the distribution risk of a project. Simulation can be very beneficial in risk assessment. Through these various methods, there are many ways to incorporate risk in the evaluation of a capital budgeting decision. The paper will also examine several different aspects of risk and how it can be incorporated into a project to increase the accuracy of the net present value. By doing this, we hope to inform financial managers of the benefits of using these methods and convince them to utilize them when making capital budgeting decisions. Following the examination of these methods, the paper will present an example that employs each method in a comprehensive manner so that the reader may better understand how to apply them. Finally, the paper will conclude with a summary of the methods and findings.
1.2 Importance of Sensitivity Analysis and Risk Incorporation
Sensitivity analysis is the effect of change in a dependent variable when an independent variable is changed. Such analysis is of crucial importance in taking investment decisions, especially in capital budgeting, because of the long-term and irreversible nature of the decisions. There is no point in taking a decision now that something cannot be done in the future, unless one can foresee that future conditions will make the thing more valuable to do then. Then postponing the decision is an immediate choice. If managers knew precisely the future economic conditions in terms of the variables such as costs of material, inflation rate, labor, etc., they could plug these into their capital budgeting model and then make an exact decision. Unfortunately, nobody knows the future and assumptions concerning the future are based on forecasting of the economic variables which are always subject to error. Now comes the question of what to do given an error in the forecast. Generally, the future variable is assumed to be more or less known and a range of values is assigned to it. Here, in between the decision made now and the variable, there exists an optimal strategy to reach the decision and the variable can be used as an independent variable. Given that capital budgeting decisions are usually taken over a period of time with the outlay of money at various times, the decision variable may be an outlay which can be seen as an investment at the different times and the variable its rate of return. Now a rate of return can be a very deciding factor to continue or abandon a certain investment and probability in the case of abandonment is that the investment is not worthwhile. To relate this to an earlier example, if an optimal strategy for a series of decisions exists and the probable rate of return on the investment is known, then a decision can be mapped to the rate of return and investment, and it is possible to simulate a series of decisions using the decision variables and stopping the simulation at a time if the investment is abandoned. Simulation techniques are very flexible and complicated ones can be used to directly replicate the real system and answer what would happen if a change were made.
2. Qualitative Steps in Conducting a Sensitivity Analysis
2.1 Identifying Key Variables
2.2 Determining the Range of Values
2.3 Assessing the Impact on Outcomes
3. Quantitative Steps in Conducting a Sensitivity Analysis
3.1 Assigning Probability Distributions to Variables
3.2 Performing Monte Carlo Simulations
3.3 Analyzing the Results
4. Incorporating Project Risk into Capital Budgeting
4.1 Evaluating Risk Factors
4.2 Adjusting Cash Flows and Discount Rates
4.3 Assessing the Impact on Project Viability
5. References