Advanced Capital Budgeting (Sensitivity, Break-even, Simulation, and Decision Tree Analyses)

Vocabulary terms and definitions covering advanced capital budgeting techniques including sensitivity, break-even, simulation, and decision tree analysis as presented by Dr Chander Shekhar.

Project Cash Flow Risk

The riskiness of a project that is reflected in the discount rate $k$, where the cost of equity usually involves strong assumptions and modeling error.

Sensitivity Analysis

A technique used to analyse the effects of changing one input variable while holding all else constant to determine a range of $NPV$ estimates (also known as a "what-if" analysis).

Break-even Analysis

A specific project risk analysis tool used to determine how bad sales or costs can get such that the resulting Net Present Value ($NPV$) is exactly $0$.

Simulation Analysis

A technique—also known as Monte Carlo Simulation—that iteratively evaluates a deterministic model using sets of random numbers from probability distributions as inputs.

Scenario Analysis

A specific form of sensitivity analysis where managers imagine a scenario where best or worst values are simultaneously realized for all variables of interest to compute the $NPV$.

Decision Tree Analysis

A method of evaluating alternatives that involve a sequence of decisions over time, utilizing estimates of event probabilities and cash flows.

Roll-back Procedure

A multi-step process in decision tree analysis where the most distant decision is assessed first, followed by the next most distant, until today's decision is reached.

Tangible Assets

Often referred to as "assets in place," which are part of the assets that generate cash flow in a corporation.

Intangible Assets

Identified as "growth assets" within the big picture of corporate finance assets.

Margin of Safety

A concept from Warren Buffett’s approach suggesting managers should focus on future cash flows and safety margins rather than obsessing over the precise cost of equity.

Sensitivity NPV Range

The difference between the optimistic and pessimistic $NPV$ estimates used to identify which underlying key variables most affect a project's success.

Prob. ($NPV < 0$)

A statistical result from simulation analysis representing the probability that a project will destroy wealth.

$95\, \%$ Central Interval

A distribution range in simulation analysis showing the possible Net Present Value outcomes between the $2.5\, \%$ and $97.5\, \%$ percentiles.

Opportunity Cost of Capital

The required rate of return (often denoted as $10\, \%\, p.a.$ in lecture examples) used to discount future cash flows back to the present value.