Application of Monte Carlo Simulation in Capital Budgeting
|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. | |[pic] | |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....
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