A Monte Carlo simulation looks at all the different potential scenarios of a project
It simulates these potential scenarios (using probabilities) many. many times resulting in a distribution curve of all possible cash flows (including an expected NPV)
The steps to do this simulation are as follows:
Specify all Major Variables
Eg Sales, Costs etc
Specify any relationships between those variables
Assign Probabilities to those variables
There are 2 projects: A and B
Which project should we invest in?
Project A has a lower average profit but is also less risky (less variability of possible profits).
Project B has a higher average profit but is also more risky (more variability of possible profits).
There is no correct answer.
The simulation doesn't say which is the better project, just the expected value and the distribution (Standard deviations etc)
If the business is willing to take on risk, they may prefer project B since it has the higher average return.
However, if the business would prefer to minimise its exposure to risk, it would take on project A.
This has a lower risk but also a lower average return.