Question

Explain how the cash flow statement and the income statement are similar and, in turn, how they are different. (You may want to form two columns.) Discuss the important differences between sensitivity analysis and scenario analysis in the risk analysis of capital budgeting and, maybe more importantly, why these tools are used by analysts. What, if anything, does Monte Carlo simulation add to the discussion of project risk

Answer 1

The main similarity is that both statements measure company's performance over a period. However it only captures the sources of cash received by the comapny and how same has been spent unlike income statement where non cash items like depreciation and amortization are also considered. The main link between them is through net profit/loss which is the end result of income statement and starting point of a cash flow statement.

Sensitivity analysis tries to study impact of change in one factor keeping others constant. While scenario analysis is about trying to determine net present value under different situations in which the factors do not remain constant.

These are considered exteremely useful for studying risk. It prepares an enterprise for the worst possible situation beforehand. Both of these models are highly flexible and very much dynamic in nature.

Monte Carlo simulation is a mathematical method in which we can measure risk with a number of different simulations or trials all of which habe different outcomes. Various probabilities for each course of action are chosen using random number tables so its very much independent in nature. It makes use of many probability distribution for a factor which is not certain and results are calculated over a large number of trials each having different outputs. The results shown by this simulation are very result oriented, it shows how likely the said result can take place so is very flexible and widely used in analyzing project risk.