AFMP4
Syllabus B. Advanced Investment Appraisal B1. Discounted cash flow techniques

B1bi. Monte Carlo simulation 11 / 14

Syllabus B1bi)

b) Outline the application of Monte Carlo simulation to investment appraisal.

Candidates will not be expected to undertake simulations in an examination context but will be expected to demonstrate an understanding of:
i) The significance of the simulation output and the assessment of the likelihood of project success

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:

  1. Specify all Major Variables

    Eg Sales, Costs etc

  2. Specify any relationships between those variables

  3. Assign Probabilities to those variables

Illustration:

There are 2 projects: A and B

Required:

Which project should we invest in?

Solution

  • 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.