Question

1. After applying Monte Carlo Simulation for a potential investment opportunity, you observed that the mean of the NPV distribution generated from the 10,000 iterations of this investment opportunity was $320 million and the Value at Risk (VAR) was $-550 million. Present a balanced recommendation based on these simulation results regarding whether or not the firm should make this investment.

Answer 1

Monte Carlo Simulation, is one of the method to make a capital budgeting decisions. Here various scenario based analysis is done and results are found. The analysis is repeated n number of times by changing various variables.

Mean of the simulation was 320 million. On an average we expect to earn 320 million. However Value at risk is -550 milion. That means in the worst case scenario we expect to lose a 550 million.

A decision needs to be made, if the firm is prepared to take a risk of losing 550 million in order to earn an average of 320 million. From the given simulation we should also find the confidence interval. What is the confidence of atleast earning a positive return.

With the given data and information it is difficult to conclude whether we should invest in project or not. We need to look at the overall risk appetite of the firm and how much worst case risk a firm can bear without going under liquidation.