Question

what are the tools used to perform risk analysis in capital budgeting? explain in brief with their drawbacks

Answer 1

The tools used to perform risk analysis in capital budgeting are :

• Scenario analysis - This involves applying capital budgeting methods to different likely scenarios. This would enable the analyst to evaluate the impact of different scenarios on the NPV/IRR. The drawback of this method is that the probabilities of different scenarios must be estimated, which can be difficult
• Sensitivity analysis - This is where the inputs such as sales, costs, investment etc. are changed to determine their impact on NPV. The key inputs are changed by a small value (usually 1%) and the change in NPV is evaluated. The drawback of this method is that there are many key inputs, and the number of possible combinations are huge.
• Monte Carlo simulation - In this method, all the possible changes in inputs/scenarios are modelled, and the resulting NPV is determined. This gives the output in a visual model where the likely distribution of NPV can be seen. The drawback of this method is that it requires complex computer models because of the huge number-crunching involved