Question

Consider the role of simulation analysis and decision trees in capital budgeting risk analysis. Describe the advantages offered by each technique. Describe a scenario that the technique would be appropriate to apply to and explain what you would expect to learn from application of that tool.

Write your response as a one-page memo. Post your memo in the discussion forum and solicit feedback from your classmates.

Answer 1

The advantage of Monte Carlo simulation or simply the simulation analysis is that it is able to handle multiple moving, and possible related inputs. As the number of factors increases, it becomes harder to figure out the base case. statistical analsis through simulation is great at handling problems with multiple, inter related and uncertain factors.

The advantage of decision tree is its ability to assign specific values to problem, decisions, and outcomes of each decision. Every possible scenario from a decision finds representation by a clear fork and node, enabling viewing all possible solutions clearly in a single view.

The Monte Carlo method is designed to find out what happens to the outcome on average when there are changes in the inputs.

The investor estimates the probability or distribution of every factor that could change the result of the investment. Then, he essentially uses the distribution to run many simulations of all the inputs to see how they affect the output and then finds the average output.

A decision tree is a decision support tool that uses a tree- like graph or model of decisions and their possible consequences, including chance event outcomes, resource costs, and utility. They help to identify the strategy that is most likely to reach the desired goal. For an investor, this may be used to help determine which bond to buy in order to get the highest expected return with only a certain amount of risk.