Monte-Carlo Simulation and Capital Budgeting
In this section, we provide an example of how Monte-Carlo Simulation can be used for Capital Budgeting.
Example
The Yum Yum corporation is considering the problem of marketing a new chocolate.
The investment required in the project is Rs. 2,00,000. There are two factors that are uncertain - annual demand & profit. The management has the past data regarding the possible levels of two factors.
| Annual Demand | Probability | Profit | Probability |
|---|---|---|---|
| 1000 | 0.10 | 3.00 | 0.10 |
| 2000 | 0.20 | 5.00 | 0.20 |
| 3000 | 0.40 | 7.00 | 0.40 |
| 4000 | 0.20 | 9.00 | 0.20 |
| 5000 | 0.10 | 10.00 | 0.10 |
Using Monte-Carlo Simulation, determine the following:
- return on investment
- average profit
- average demand
Solution.
Table
| S.No. | Random No. | Simulated Demand (SD) | Random No. | Simulated Profit (SP) | Return (%) (SD X SP X 100) / 200000 |
|---|---|---|---|---|---|
| 1 | 35 | 3000 | 15 | 5 | 7.5 |
| 2 | 55 | 3000 | 80 | 9 | 13.5 |
| 3 | 10 | 2000 | 50 | 7 | 7.0 |
| 4 | 30 | 3000 | 90 | 10 | 15 |
| 5 | 70 | 4000 | 30 | 7 | 14 |
| 6 | 90 | 5000 | 60 | 7 | 17.5 |
| 7 | 25 | 2000 | 25 | 5 | 5 |
| 8 | 52 | 3000 | 62 | 7 | 10.5 |
| 9 | 62 | 3000 | 10 | 5 | 7.5 |
| 10 | 31 | 3000 | 2 | 3 | 4.5 |
| Total | 31000 | 65 |
Average profit = 65/10 = 6.5.
Average demand = 31000/10 = 3100.
