The Use of Simulation, Expected Values and Sensitivity

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Simulation

Simulation is a modeling technique used mainly in capital investment appraisal decisions.

Computer models can be built to simulate real life scenarios. The model will predict what range of returns an investor could expect from a given decision without having risked any actual cash.

The models use random number tables to generate possible values for the uncertainty the business is subject to.

Since the time and costs involved can be more that benefits gained, computer technology is assisting in bringing down the cost of such risk analysis.

Models can become extremely complex and probability distributions may be difficult to formulate.

Expected Values (EV)

The ‘expected value’ rule calculates the average return that will be made if a decision is repeated again and again.

It does this by weighting each of the possible outcomes with their relative probability of occurring.

It is the weighted arithmetic mean of the possible outcomes.

The likelihood that an event will occur is known as its probability.

This is normally expressed in decimal form with a value between 0 and 1.

A value of 0 denotes a nil likelihood of occurrence whereas a value of 1 signifies absolute certainty.

A probability of 0.4 means that the event is expected to occur four times out of ten.

The total of the probabilities for events that can possibly occur must sum up to 1.0.

An expected value is computed by multiplying the value of each possible outcome by the probability of that outcome, and summing the results.

EV = ∑px

Where:
p = probability of the outcome 
 x= the possible outcome

A risk neutral investor will generally make his decisions based on maximizing EV.

Sensitivity Analysis

This calculates the maximum percentage change in a variable before a decision would change

The lower % variables that are therefore the most important for the decision under review.

Advantages of Sensitivity Analysis

  1. Easy to understand

  2. Highlights key variables

Disadvantages of Sensitivity Analysis

  1. Looks at variable only one at a time

  2. It does not assess the probability of any change occurring

  3. Does not offer a clear decision rule; management judgement is still required

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