This is a very simple example showing how Monte Carlo Simulation will consider uncertainty in capital budgeting models. I replace static variables with simple triangular distributions to calculate an expected range of outcomes rather than the original single expected outcome. This allows us to better understand what to expect with the project and shows us just how much each variable affects the project\’s profitability.
Increasing Capital Budgeting Insight Using Monte Carlo Simulation / War Gaming with NPV / EVA Models
1. Approach A standard discounted cash flow model was created and populated with expected values: Project 123-XYZ.xls NPV from the static model = $11.3MM No terminal value The static discounted cash flow model was then updated to become a dynamic model where expected values were replaced with probability distributions in the following variables: CAPEX Revenue from Product A Cost savings from Product A ∆ plant operating costs 1,000 iterations were run by @Risk simulation software: Mean NPV = $8.8MM NPV range = ($3.5MM) - $18.1MM Sensitivity analysis recorded Most sensitive variable: Revenue from Product A (0.87 correlation) Least sensitive variable: CAPEX (-0.01 correlation)
20. No ∆working capitalNPV is guaranteed to not be exactly $11.3MM. How much +/- is a matter of many probabilities combining. (Model forecasts 30% prob. NPV will be >$11MM)
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23. Yearly revenue from Product A is ~2x the value of fuel savings from Product A
24. Plant costs each year are about the same as the revenue from Product A. However, plant costs have more certainty than the revenue estimatesCost Savings Cost Savings Cost