1.Define sensitivity analysis and Monte Carlo simulation.

2.Which of the following simulation techniques computes as many as 1,000 net present values, based on multiple values for each cash flow?

A)   Monte Carlo simulation.

B)   Scenario analysis.

C)   Sensitivity analysis.

D)   Variable input estimation.

3.Which of the following statements about sensitivity analysis is least accurate?

A)   Sensitivity analysis alters a single independent variable to determine the impact on the output variable.

B)   Sensitivity analysis starts with the best-case scenario.

C)   Sensitivity analysis can be applied to each of the independent variables used in analysis.

D)   The steeper the slope of the NPV versus the variable, the more sensitive the output variable is to a change in the input variable.

4.Which of the following statements about Monte Carlo simulation is FALSE? Monte Carlo simulation:

A)   can be useful for estimating the stand-alone risk of a project.

B)   is the most accurate risk analysis tool because it is based on real data.

C)   is capable of using probability distributions for variables as input data.

D)   produces both an expected value and a measure of the variability of that value.

5.Which of the following statements about risk analysis techniques is FALSE?

A)   In sensitivity analysis, the dependent variable is plotted on the y-axis and the independent variable on the x-axis. The steeper the slope on the resulting line the less sensitive the dependent variable is to changes in the independent variable.

B)   Sensitivity analysis is incomplete, because it fails to consider the probability distributions of the independent variables.

C)   In Monte Carlo simulation, probable future events are simulated on a computer generating estimated rates of return and risk indexes.

D)   Scenario analysis is a risk analysis technique that considers both the sensitivity of the dependent variable to changes in the independent variables and the range of likely values of these variables.

6.Which of the following statements is CORRECT?

A)   In a graphical depiction of sensitivity analysis, the project with the steeper line would be considered most risky, because a small error in estimating a variable, such as unit sales, will produce a large error in the net present value's prediction.

B)   The financial manager of a large corporation should view stand alone risk as most important because of its impact on debt capacity, credit worthiness, and job stability.

C)   Monte Carlo simulations produce both the required return of a security and the relevant WACC.

D)   A company that does not adjust the discount rate for differences in project risk is likely to accept an excessive number of low risk projects.

1.Define sensitivity analysis and Monte Carlo simulation.

The correct answer was C)

Monte Carlo simulation assumes a specified distribution to generate random samples in order to estimate true distribution parameters.

When a firm looks at the sensitivity of only one variable, holding all others constant, they are performing sensitivity analysis.

2.Which of the following simulation techniques computes as many as 1,000 net present values, based on multiple values for each cash flow?

A)   Monte Carlo simulation.

B)   Scenario analysis.

C)   Sensitivity analysis.

D)   Variable input estimation.

The correct answer was A)

Through the computation of multiple net present values, Monte Carlo simulation provides insight to the possible distribution of net present values arising from a project. Scenario analysis, on the other hand focuses on the worst case, best case, and base case. Sensitivity analysis inputs could be modified 1,000 times, but typically only one variable is changed at a time from the base case scenario. Although variable input estimation is not a simulation technique, financial managers must be careful to select reasonable variables for the input parameters.

3.Which of the following statements about sensitivity analysis is least accurate?

A)   Sensitivity analysis alters a single independent variable to determine the impact on the output variable.

B)   Sensitivity analysis starts with the best-case scenario.

C)   Sensitivity analysis can be applied to each of the independent variables used in analysis.

D)   The steeper the slope of the NPV versus the variable, the more sensitive the output variable is to a change in the input variable.

The correct answer was B)

In sensitivity analysis, you start with the “base-case” scenario. In this case, you use the company's projected cash flows as the inputs to calculate the net present value (NPV) of a project. Hopefully, supporters of a project are providing realistic information, although it may be on the optimistic side. In a “best-case” scenario, revenues would be excessively high, while expenses would be excessively low.

4.Which of the following statements about Monte Carlo simulation is FALSE? Monte Carlo simulation:

A)   can be useful for estimating the stand-alone risk of a project.

B)   is the most accurate risk analysis tool because it is based on real data.

C)   is capable of using probability distributions for variables as input data.

D)   produces both an expected value and a measure of the variability of that value.

The correct answer was B)

Monte Carlo uses computer simulated data not real data to estimate risk. It can be a very useful tool when there is a very small sample size for analysis.

5.Which of the following statements about risk analysis techniques is FALSE?

A)   In sensitivity analysis, the dependent variable is plotted on the y-axis and the independent variable on the x-axis. The steeper the slope on the resulting line the less sensitive the dependent variable is to changes in the independent variable.

B)   Sensitivity analysis is incomplete, because it fails to consider the probability distributions of the independent variables.

C)   In Monte Carlo simulation, probable future events are simulated on a computer generating estimated rates of return and risk indexes.

D)   Scenario analysis is a risk analysis technique that considers both the sensitivity of the dependent variable to changes in the independent variables and the range of likely values of these variables.

The correct answer was A)

In sensitivity analysis, the dependent variable is plotted on the y-axis and the independent variable on the x-axis. The steeper the slope on the resulting line the more sensitive the dependent variable is to changes in the independent variable.

6.Which of the following statements is CORRECT?

A)   In a graphical depiction of sensitivity analysis, the project with the steeper line would be considered most risky, because a small error in estimating a variable, such as unit sales, will produce a large error in the net present value's prediction.

B)   The financial manager of a large corporation should view stand alone risk as most important because of its impact on debt capacity, credit worthiness, and job stability.

C)   Monte Carlo simulations produce both the required return of a security and the relevant WACC.

D)   A company that does not adjust the discount rate for differences in project risk is likely to accept an excessive number of low risk projects.

The correct answer was A)     

The steeper the sensitivity analysis profile, the more important it is to accurately forecast that variable’s true level. Financial managers are typically most sensitive to corporate, or within firm risk. Monte Carlo simulations produce measures of anticipated net present value means and distributions, not the required return and WACC. Those companies not reducing required returns for projects with lower risk will end up accepting a higher number of high risk projects.