Monte Carlo Application in Capital Budgeting

Application of Monte Carlo Simulation in Capital Budgeting

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|by Prit, Aug 2, 2008 |
|The usefulness of Monte carlo Simulation in Capital Budgeting and the processes involved in Monte Carlo Simulation. It also |
|highlights the advantages in some situation compared to other deterministic models where uncertainty is the norm. |
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|Capital budgeting is an important area in Financial Management. Capital Budgeting means the investment in capital projects and|
|identify the projects, which has the highest value adding to the company at the cost of capital. It uses net present value of |
|future cash flows discounted at the appropriate cost of capital and compares it with initial investment and to see whether it |
|is a positive net present value. If the present value is less than the initial investment then the project is rejected. That |
|is the net present value is dependent on future cash flows. |
|In a deterministic model the cash flows are forecasted as a single figure and scenarios are considered one by one and |
|uncertainty of cash flow is not considered. That is in a traditional analysis of net preset value all possible combinations |
|are not considered simultaneously and there is not assessment of the likelihood of getting a positive net present value. In |
|effect the traditional analysis is not adequate and may mislead the decision maker and the net present value may not |
|materialize and there fore the company may looses due to error in judgment using the incorrect analysis which overlooks the |
|complexity of combination of scenarios.