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

Cashflow statement and income statement are similar because both provide the financial status of company. Both tells whether company is performing good or not. Though income statement tells whether company is generating enough cash using operation or not, cashflow statement will give broader picuture which tells which all section of cashflow adding value to company. If most of the cashflow are coming from financing then it won't be good for company because it shows that company is floating due to fianncing either by equity or debt.

Sensitivity and scenario analysis are few of the most sought after tools used for risk analysis of capital budgeting. Due to ease of its use many analysts utilize it in their analysis. Sensitivity analysis tells that how change in certain parameter will impact the outcome lets take an example of income statement where change in reveune at certain percentage will change the net income similarly if there is any change in other parameters like overhead cost, depreciation or interset expense then it will impact the net income. Whereas in scenario analysis, analyst creates different scenarios like base case, optimistic case and pessimistic case and then analyze the results.

Monte Carlo simulation is one of the widely used tool for measuring project risk, it creates lot of scenarios which can help in identifying worst cases for project. Though it is highly computaionla and costly but at the same time most effective as well. There is model risk associated with Monte Carlo simulation.