Simulation analysis is one of the important techniques that are utilized in risk analysis in capital budgeting. Simulation analysis is implemented for preparing a probability profile regarding a criterion of merit by stochastically aggregating the variable values that are associated with the opted criterion.
With the help of sensitivity analysis, the sensitivity of Net Present Value or NPV and IRR or Internal Rate of Return and many other types of criterion of merit to changes in fundamental elements can be ascertained. It offers data like the following:
In case the quantity manufactured and sold is reduced by 1 percent, other factors remaining constant, the Net Present Value also diminishes by 6 percent. This type of data, although helpful, cannot be sufficient with regards to decision making. The decision-making authority also needs to have an idea about the probability of this type of events. This data may be rendered by simulation analysis.
The process of simulation analysis can be categorized into the following steps:
Patterning the project. The project pattern demonstrates the relation between the Net Present Value with the various parameters and the external variable quantities. The parameters are regarded as variable inputs delineated by the decision-making authority and they remain unchanged in every simulation run. The external variable quantities are variable inputs that have random characteristics and are beyond the influence of the decision-making authority.
Assigning the probability distributions of external variable quantities and parameter values
Choosing a value in a stochastic manner by picking a value out of the probability distributions for every external variable quantity
Ascertaining the net present value or NPV matching the stochastically produced values of external variable quantities, as well as pre-assigned values of parameters
Performing steps 3 and 4 on several occasions for receiving a huge count of net present values (simulated)
Diagramming the net present value frequency distribution.