Question

A false sense of security can overcome a decision-maker when the net present value method is applied properly but the positive NPV results are accepted without question. Sensitivity and scenario analysis aid in the process by:

Multiple Choice
a)providing assurance that the most appropriate discount rate is being applied.
b)ensuring all estimated values are accurate.
c)ensuring the NPV value was calculated correctly.
d)providing information on a number of potential outcomes.
e)guaranteeing the NPV will be achieved.

Answer 1

Sensitivity and scenario analysis are vital tools used alongside NPV to provide information on a range of potential outcomes, which helps in assessing the risks and uncertainties of an investment decision.

Step-by-step explanation:

A false sense of security when using the net present value (NPV) method can be mitigated by employing sensitivity and scenario analysis. These analyses do not guarantee accurate future projections, but they help counteract the overconfidence by providing a range of potential outcomes. This means the decision-maker can see how the NPV might change with different assumptions, which helps in understanding the risks and uncertainties involved in the investment.

Sensitivity analysis varies key factors one at a time to assess their impact on NPV, while scenario analysis changes multiple variables simultaneously to paint a picture of what might happen under different conditions. These techniques help businesses and governments alike when they consider long-term investments, such as infrastructure projects or environmental policies, by putting side-by-side the present costs against future benefits and providing invaluable insight into the robustness of the NPV calculation against real-world uncertainties.