Monte Carlo Simulation - Essay Example

Monte Carlo Simulation al affiliation In management, capital budgeting is an essential tool in managing of a company’saccounts. The management is able to choose investments wisely, through capital budgeting in regard to those with fulfilling cash flow sand best returns. According to Mooney (2012), the financial manager of a company is obligated to decide whether an investment is commendable or not to select an investment that is more variable. Planning, coordination and consequent development of sufficient capital to be used in maximizing profits of the firm is linked to capital budgeting (Repullo & Suarez, 2014). As a company decides on investing its present assets in an effective way while expecting cash flow of income over a period of years, the capital budgeting process could be explicated. These decisions are basically dwelt on acquisition and expansion. The foundation of capital budgeting is creation of opportunities because the opportunity as observed is not defined. Prior to capital budgeting for a company needs to assess and analyze the future. Capital budgeting is done through capital expenditure. This is the immense input as investments put in the company’s acquisition of new machinery, space, and other massive input. Many companies have to make decisions that involve budgeting. These decisions are often weighty and risky considering their capital intensity. Objectives of the study The main aim of this study is to evaluate Conch Emirates investment opprotunities using techniques centered n capital budgeting. The other objective was to make recommendations founded on the Capital Budgeting Tools. Moreover, the study analyses strengths and weaknesses of venturing into a new product line. It aids in the measurement of future profitability and proper management of capital budgeting tools that lead to more positive results. Proper capital budgeting helps in keeping up with inflammatory changes and trends, projecting growth and checking if the company is achieving its objectives for future projections. Importance of the study Capital budgeting is important since it is used in decision making and the decisions are vital in the profitability and the financial health of a company. A company’s successful performance is attributed to proper capital budgeting. The decisions that pertain capital expenditure are nor easily reversible and may bring loss to the company. In making comparison between two investment opportunities, capital budgeting is an excellent tool. It aids in keeping debts in check therefore preventing losses that may arise in future. This study thereby allows proper capital budgeting that is vital in the formation of long term goals. Company Summary Conch Emirates is a middle sized company that is located in Dubai. It is managed by Mr. Abdellah, a DMC graduate. In the initial stages when it was started, the company repaired electronics such as household appliances. Over 30 years the company has undergone expansion and is now a manufacturing line of various electronic items. The Conch Pad is the major revenue producing item manaufactured by the company. The Sales for the Premier Conch Pad are excellent. The Conch Pad has a variety of new and unique features as it has many colors, specifications and design just like most new technological devices. However, the world of technology is dynamic, changing rapidly in time. Conch Emirates has realized that their premier Conch Pad has limited features in comparison with the newer models introduced in the market by other competitors. Conch Emirates spent approximately AED to develop a protype for a new Conch Pad that would be known as Conch Pad 2 that would have all the features of the existing one in addition to new features such as dual camera and a larger screen. The company has spent more AED 200,000 for marketing study to find out the expected sales for the new Conch Pad 2. The fixed costs for the operations are estimated to run AED 4,300,000 annually. The retail price for one Conch Pad 2 is AED 500. It is estimated that the Conch Emirates has 35% corporate tax rate and 10% required return rate. This new device comes with pre-existing features and additional features such as high resolution dual camera and a larger screen. It is important for the company to perform a capital expenditure study. As a result, Conch Emirates would like to analyze the viability of this investment using the various Capital Budgeting tools available. Capital Budgeting Tools Bierman & Smidt, (2014) suggests that the process of capital budgeting caan be expoundded as a company’s decision in investing its current assets in an effective way in anticipation of expected cash flow of income over a duration of time. As stated earlier, capital budgeting enables the management to select investments wisely such as those with fulfilling cash flows and best returns. It is the duty of the the company manager to decide on whether an investment is worthy or not to select an investment that is viable. In this regard, it is imporatnt that a capital budgeting is carried out for Conch Emirates’ new product, the Conch Pad 2. The Payback Period of the Project The payback period is the simplest and it is basically the decision tool. Determining the duration of paying up the initial investment that is necessary to undergo a project. The paybck period is defined as the total number of years that is needed to earn back or fully recover the capital invested in a project. In calculation of the payback period, cash flows are used and not income since this calculation does not provide information as to profitability but how fast a company can recover its investment. This is the traditional method of evaluation of decisions in capital budgeting. In its computation, the total cost of the project is taken and divided by the amount of cash flow expected to be received yearly. This gives the total number of years or the period the project will take to repay the money invested. Mathematically, the payback period is represented by; From this equation, the Payback Period for Conch Emirates is 2.11 years. Conch Emirates will earn their capital invested after 2.11 years. The Discounted Payback Period (DPP) of the project In determining the procedure of determining the profitability of a given project is referred to as the discounted payback period of the project. The DPP determines the number of years that will take for a given company to break even from the first expenditure in contrast to the Net Present Value analysis. The future cash flows that are discounted are considered at time zero. It measures the time that will be taken for the initial cash flow to be completely paid back overlooking the time value of money. Due to a deficit in the initial outlay a project whose net present values will appear to be negative. It is calculated as; Net Present Value (NPV) of the Project The net present value is calculated by finding the difference between the cost of the project and the cash flow that is generates by the project that has to be calculated. This is a common tool for effective evaluation process. Generally, in calculation of the net present value, the difference between the cost of the project and the cash flow that is generated by the project has o be calculated. Its effectiveness is accredited to the use of discounted analysis of cash flow in which the cash flows of the future are discounted at a certain rate which compensates the uncertainty of the future cash flows. The present value used in NPV indicates that the cash flows that will be earned in future are not worth the value of the cash plow presently. The projects that are independent are rejected when a negative NPV is obtained and accepted when the result is positive is the rule of NPV. In mutually exclusive events, projects, the highest value is considered and taken to be the NPV to be employed. The Net Present Value of a project is the total of all the present values of the cash income in every year and subtracting the totals of the present values of the net cash outflows in each year. A time factor in the calculation of the return on investment is included in the NPV method. The NPV method indicates that the investment is variable. Conchs NPV is affirmative and therefore a viable project. Year Random Number Sales Volume Price Cost of Capital Sales NPV Factor NPV 1 37 446600 AED525 0.12 32500000 100% $153,798,641.42 2 11 365400 AED475 0.08 41000000 91% 3 72 446600 AED525 0.12 54000000 83% 4 87 446600 AED525 0.12 47000000 75% 5 99 446600 AED525 0.12 28500000 68% Monte Carlo Simulation According to Rubinstein (2014), Monte Carlo is a mathematical technique that has been computerized to allow persons account for their decision making and quantitative analysis. In many cases, it is used by businessmen and professionals in manufacturing, engineering, insurance and finance. These simulations help the decision maker and equip them with a range of the possible outcomes and any possibility at which they will occur if any action after the decision is taken. Monte Carlo analyses the risk management by building possible result models by substitution of values of a certain range. Using a different group of random variables, results are calculated over and over from the probability functions. This implies that for there to be a complete simulation, this method could be done over and over again for more than a thousand times depending on the ranges specified for them and the number of uncertainties (Brémaud, 2013). The variables might have different probabilities, which are from the occurrence of the outcomes from the probability distributions. Some of these distributions are normal, uniform, triangular, lognormal, and discrete among others. Monte Carlo methods in finance are usually in analyzing investment viability and company portfolios. The Monte Carlo methods were first introduced in finance in the year 1964. These methods have since evolved into what we call Monte Carlo simulation. Monte Carlo simulation is a method used to produce thousands of series of possible outcomes of expected or possible returns. Monte Carlo simulation essentially generates all possible outcomes and these are used in the management of risk. Findings From the analysis using the Monte Carlo Simulations, the mean (expected value) for the NPV is 153,798,641 with a standard deviation of 0.00057. The very low standard deviation value implied that there were very small variations in the observed values. The probability of having a positive NPV is close to 100%. Thus, for this particular project that Conch Emirates want to start, the risk of having a positive NPV is very high. The larger the Net Present Value, the less likely for the figure to be negative and this consequently means that the investment is more attractive to the concerned parties. The NPV for Conch Emirates’ Conch Pad too is positive. The minimum NPV is a positive figure and so is the maximum. Conch Emirates Company should accept this investment as viable. Based on the capital budgeting tools, it is clear that the Net Present Value is a positive figure. The probability of this figure being positive is absolute. It is also important to note that the larger the Net Present Value, the more attractive investment is. Thus, for this reason, Conch Emirates should accept this offer. NPV   Mean 153798641.4 SD 0.00057 Median 153798641.4 Kurtosis 1.000005 Skewness 0.1352882 Conclusion Capital budgeting is a very important part of a company’s accounts management.It is a required tool in management. Capital budgeting enables management to select investments wisely, that is, those with fulfilling cash flows and best returns. It is therefore a duty of the financial manager of a company to decide on whether an investment is worthy or not or to choose on a more viable investment. A capital budgeting process can be expounded as a company’s decision in investing its current assets in an effective way in anticipation of expected cash flow of income over a period of years. These investment decisions include but are not limited to acquisition and expansion. One of the prerequisites of Capital Budgeting for a company is the need to look ahead and analyze the future. Capital budgeting is done through Capital expenditure. Capital expenditure is massive investments put in acquisition of new machinery, land or office space among other huge investments. Capital budgeting through simulation is done through the Monte Carlo methods. Monte Carlo simulation is a method used to produce thousands of series of possible outcomes of expected or possible returns. Monte Carlo simulation essentially generates all possible outcomes and these are used in the management of risk. In these methods, repeated random sampling is used. This method has its advantages. They provide all outcomes unlike spreadsheets which produce a few outcomes. Simulation on the other hand provides all possible outcomes of possible returns. Moreover, they also include the mean Net Present Value that results from Monte Carlo simulation is much closer to the true means. This is not easily attainable on a spreadsheet. Finally they included the fact that a firm is able to attain the probability if or if not the company will achieve its set goals and objectives. References Bierman, H., & Smidt, S. (2014). The capital budgeting decision. New York: Macmillan. Brémaud, P. (2013). Monte Carlo simulation and finance. New York: Springer Publishers. Johnson, R. W. (2013). Capital budgeting. Belmont: Wadsworth Pub. Co. Mooney, C. Z. (2012). Monte Carlo simulation by Christopher Z Mooney . New York: Oxford University Press. Repullo, R., & Suarez, J. (2014). Venture capital finance. London: Centre for Economic Policy Research. Rubinstein, R. Y. (2014). Simulation and the monte carlo method. New York: Wiley Publishers. Appendix: Figure 1: NPV Profile for Cronch Table 1: NPV Monte Carlo simulation NPV   Mean 153798641.4 SD 0.00057 Median 153798641.4 Kurtosis 1.000005 Skewness 0.1352882 Read More