CIMA P2 Syllabus D. Risk and Control - Monte Carlo Simulation - Notes ^{13 / 13}

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.