- CFA Exams
- CFA Level I Exam
- Study Session 3. Quantitative Methods (2)
- Reading 9. Excerpt from Probabilistic Approaches: Scenario Analysis, Decision Trees, and Simulations
- Subject 3. An overall assessment of probabilistic risk assessment approaches

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**CFA Practice Question**

Consider the following scenario. An analyst has computed the net present value of a project, using projected cash flows and a risk-adjusted discount rate. The net present value is positive. He proceeds to do sensitivity analysis on the NPV, changing the variables, and discovers that the NPV turns negative fairly frequently. He therefore rejects the project. What problems can you identify in this process?

Correct Answer: 2 problems

There are two primary problems with sensitivity analyses:

a. It can be argued that risk has been considered twice, once in the discount rate and again in the sensitivity analysis. If the risk assessment in the discount rate is correct, a project with a positive net present value is a good project, no matter what the sensitivity analysis concludes.

b. The only risk that should be considered in investment analysis is market risk or non-diversifiable risk. In most "what-if" analysis, the variables analyzed are firm-specific variables, which at the margin are diversifiable.

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