The cash flow of a project could be estimated by taking the net operating profit after taxes minus net investment in operating capital. To accurately do this “the company must obtain information from various departments such as engineering and marketing, ensure everyone involved with the forecast uses a consistent set of realistic economic assumptions, and make sure that no biases are inherent in the forecasts” (Ehrhardt & Brinham, 2009).
“Sensitivity analysis is a technique that indicates how much NPV will change in response to a given change in an input variable, other things held constant” (Ehrhardt & Brinham, 2009).
Scenario Analysis is the process of approximating the expected worth of a portfolio after a certain amount of time (Investopedia, 2010). With Scenario analysis, the financial analyst begins with the base case, or most likely set of values for the input variables. He then asks for all the company’s departments to provide best case scenario and worst case scenario analysis. Once given these he will combine all the departments best and worse case scenarios and will come up with the scenario analysis across the entire company.
Monte Carlo simulation combines both sensitivity and scenario analysis for multiple outcomes. “In a simulation analysis, a probability distribution is assigned to each input variable sales in units, the sales price, the variable cost per unit, and so on. The computer begins by picking a random value for each variable from its probability distribution. Those values are then input into the model, the project’s NPV is calculated, and the NPV is stored in the computer’s memory. Next, a second set of input values is selected from the input variables’ probability distributions, and a second NPV is calculated” (Ehrhardt & Brinham, 2009).
All of these methods show how NPV can change in different situations and provide incite to how risk can change in different environments. As for using the computer software for managing...