Question

__________ is often employed in order to better understand the forecasting risk (error) that is inherent when estimating financial value using Discounted Cash Flow techniques.

D. all of the above

A. Sensitivity analysis

B. Scenario analysis

C. Monte Carlo simulation

Answer 1

Q. __________ is often employed in order to better understand the forecasting risk (error) that is inherent when estimating financial value using Discounted Cash Flow techniques.

Answer: Option D. all of the above

Project appraisal involves forecasting the values of costs and benefits using the best information available. An inherent problem with the CBA approach is the difficulty in predicting these values. The estimated values of costs and benefits may not materialise as expected due to uncertainty and risk. There may also be biases in the analysis. The risks of adverse conditions and the potential uncertainty associated with each option should be identified and factored in to the decision making process. Realistic assumptions should be made which reduce the element of uncertainty and risk minimisation strategies should be put in place. It is important that steps are taken to manage risk and uncertainty as part of the appraisal process. The assessment of risk and uncertainty is one the most important components of a CBA and should be given significant attention. There are a number of key steps which should be taken:

1. Ensuring the data and assumptions underlying the estimation of costs and benefits are reliable and realistic

2. Identifying risks e.g. examining each variable to assess the level of uncertainty involved

3. Using risk assessment techniques to assess the level of risk and the impact of risk on project performance including such techniques as:

a. Sensitivity analysis

b. Scenario analysis

c. Expected values

d. Monte Carlo analysis

4. Devising a risk management strategy, including measures to contain, avoid and mitigate risks, as appropriate

5. Communicating the risk management strategy to relevant stakeholders

Sensitivity Analysis

Sensitivity analysis should always be carried out as part of a CBA. Sensitivity analysis describes the process of establishing the extent to which the outcome of the cost benefit analysis is sensitive to changes in the values of the input variables. It generally involves recalculating the NPV based on changes to the values of variables and assumptions. A comprehensive approach to sensitivity analysis allows the analyst to determine those variables and assumptions to which the NPV is most sensitive

Scenario Analysis

Scenario analysis is similar to sensitivity analysis as outlined above. The sensitivity analysis allows users of the CBA methodology to identify those individual parameters and assumptions to which the outcome of the analysis is most sensitive.

Monte Carlo Analysis

Monte Carlo analysis is a risk modelling technique that uses statistical sampling and probability distributions to simulate the effects of uncertain variables on model outcomes. It can be used to model the effects of key variables on the NPV of a given proposal. The approach provides a systematic assessment of the combined effects of multiple sources of risk in key variables and can also allow for known correlations between these variables. The analysis can generate a probability distribution for the NPV.