Homework answers / question archive / Using sensitivity analysis one can analyze the factors that might have a large impact on the project cash flows

Using sensitivity analysis one can analyze the factors that might have a large impact on the project cash flows

Finance

Share With

Using sensitivity analysis one can analyze the factors that might have a large impact on the project cash flows. For some projects, say, labor costs might have a large impact on the cash flows. That means that small changes in labor costs will cause a large change in the cash flows of the project. This helps the financial manager and the project manager to focus on a few key variables and take corrective actions wherever possible. One drawback of sensitivity analysis is that it always gives ambiguous results.

Discuss the following:

As the CFO of Marie LeBlanc’s workover rig company, you have been involved in a serious discourse with your analysts and have considered the many financial components to ascertain the probabilities of success in moving forward to acquire drilling rigs. You present to Ms. LeBlanc your findings and state the “Monte Carlo simulation supports the “real options” valuation, assuming we can maintain the “economic rents” in the current environment”. Ms. LeBlanc looks at you as if you have lost your mind and asks, “Three martini lunch again? Spit it out. Speak English or French, not whatever it is you are spouting. Say it so I can understand it.” Theophile Savoie, Ms. LeBlanc’s COO, agrees and with a strong merci, asks for you to say it again so he can understand as well. Being a very smart CFO, explain it again so Ms. LeBlanc and Mr. Savoie understand.

Using NPV will lead to the correct decision when evaluating projects with very different cash flow patterns over time. The firm can use the IRR on the incremental cash flows of the long-term project compared to the short-term project in order to achieve the correct decision, i.e., the same decision that NPV would recommend.

Discuss the following:

Marie LeBlanc has decided to move forward and acquire the drilling rigs to start a new line of service for her company. It is a very expensive undertaking. It is the first time she has personally borrowed $30 million and she is quite nervous that all works right. Recognizing she needs to make sure there is no stumbling along the pathway to success she assigns you, the CFO, to take the lead. Enlighten Ms. LeBlanc to your capital budgeting process.