Replacement Decision, Sensitivity Analysis, Introduction to Financial Analytics
Replacement Decision is one of the most important classifications of capital budgeting. It is a decision concerning whether an existing asset should be replaced by a newer version of the same machine or even a different type of machine that has the same functionality as the existing machine.
Decision regarding replacement of an existing asset with another is based on the net present value and internal rate of return of the incremental cash flows, i.e. the difference between periodic net cash flows if the existing asset is kept and the periodic net cash flows if the asset is replaced.
Sensitivity analysis is the study of how the uncertainty in the output of a mathematical model or system (numerical or otherwise) can be apportioned to different sources of uncertainty in its inputs.
A related practice is uncertainty analysis, which has a greater focus on uncertainty quantification and propagation of uncertainty; ideally, uncertainty and sensitivity analysis should be run in tandem.
The process of recalculating outcomes under alternative assumptions to determine the impact of a variable under sensitivity analysis can be useful for a range of purposes, including:-
- Testing the robustness of the results of a model or system in the presence of uncertainty.
- Increased understanding of the relationships between input and output variables in a system or model.
- Uncertainty reduction, through the identification of model inputs that cause significant uncertainty in the output and should therefore be the focus of attention in order to increase robustness (perhaps by further research).
- Searching for errors in the model (by encountering unexpected relationships between inputs and outputs).
- Model simplification – fixing model inputs that have no effect on the output, or identifying and removing redundant parts of the model structure.
- Enhancing communication from modelers to decision makers (e.g. by making recommendations more credible, understandable, compelling or persuasive).
- Finding regions in the space of input factors for which the model output is either maximum or minimum or meets some optimum criterion (see optimization and Monte Carlo filtering).
- In case of calibrating models with large number of parameters, a primary sensitivity test can ease the calibration stage by focusing on the sensitive parameters. Not knowing the sensitivity of parameters can result in time being uselessly spent on non-sensitive ones.
- To seek to identify important connections between observations, model inputs, and predictions or forecasts, leading to the development of better models.
INTRODUCTION TO FINANCIAL ANALYTICS
Financial Statement Analysis is a method of reviewing and analyzing a company’s accounting reports (financial statements) in order to gauge its past, present or projected future performance. This process of reviewing the financial statements allows for better economic decision making.
Globally, publicly listed companies are required by law to file their financial statements with the relevant authorities. For example, publicly listed firms in America are required to submit their financial statements to the Securities and Exchange Commission (SEC). Firms are also obligated to provide their financial statements in the annual report that they share with their stakeholders. As financial statements are prepared in order to meet requirements, the second step in the process is to analyze them effectively so that future profitability and cash flows can be forecasted.