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Concepts
Decision Tree- It is the schematic way of representing alternative sequential decisions and the
possible outcomes from these decisions. In this case there is the probability of events
happening. Decision tree gives us the direction to follow the path and on every path there is
the NPV calculation. As all the events are interrelated so we have to follow certain paths to
get the maximum NPV or cash flows. Every decision we take have the effect on the other
decisions and by this decision tree we can clearly see the paths to be followed and what
decisions to be made. After the entire decision tree the NPV is calculated on the formula for
each path-
Expected Payoff = (probability of success X payoff if successful) + (probability of failure
X payoff if failure)
Sensitivity Analysis- It is also known as What-if analysis and BOP analysis. It examines how
sensitivity a particular NPV calculation is to change in various assumptions. In this various
conditions are taken like pessimistic and optimistic where the prediction is different one will
have lower than predicted and the other will have higher the predicted and than the effect on
NPV is checked. It tries to find out various effects and even to calculate the breakeven points.
Standard sensitivity analysis calls for an NPV calculation for all three possibilities of single
variable, along with the expected forecast for all other variables. In case the pessimistic as
well as optimistic analysis shows positive NPV than in that case more of information is
required. this is the drawback of sensitivity analysis. In this situation managers do scenario
analysis which is just a variance of sensitivi ...