A simulation is basically a computer model that attempts to replicate a reallife situation. In Finance, simulation analysis is a model that is applied to analyze large projects and determine how target variables are affected based on changes in input variables. The model uses simulations to predict how the outcome of a decision would vary if we tweak a set of input variables in a given range.
Unlike scenario analysis and sensitivity analysis, simulation analysis does not offer a single result. Instead, it offers a range of probable outcomes due to the movement of variables.
In simulation analysis, each input’s statistical distribution is required. Simulations are usually run to check the effect of constantly changing inputs on the outputs. The outputs’ average is then used to get the estimated output.
Simulation analysis works best when there are multiple inputs that are unrelated and may all change on their own.
Simulation analysis is applied in many areas of business such as bond pricing. However, it is especially useful when we estimate the “base case” that is difficult to do by hand.
Simulation Analysis contains the following steps −
Let us discuss these steps in detail.
The variables that influence cash inflow and outflow must be identified first. For example, suppose a company launches a new product in the market. In such a case, the variables that must be considered include investment, market size, market growth, market share, fixed costs, variable costs, price, terminal value, and product lifecycle.
The second step involves the specification of formulas. For example, the volume of sales is dependent upon the market size and market share, and revenue deals with sales volume and price. Similarly, sales volume depends on market sales, production, and variable and fixed costs.
The third step is to indicate the probability distribution for each selected variable. Some variables will have more probability distribution than others. For example, it is tough to predict price or market growth with more confidence.
Finally, a computer program should be built to show the probability distribution for each variable. The value should also calculate the project’s Net Present Value (NPV). The computer should generate a large number of such scenarios, show and store them. These stored values are then printed as the probability distribution of the project’s NPV along with the estimated NPV and the standard deviation.
The discount rate to calculate the distribution is the risk-free rate. As the simulation is used to calculate the project’s cash flows, the discount rate will show only the time value of money.
Simulation analysis is however not the only best way to measure the effect of variables in an investment scenario. The best procedure to judge an investment should be chosen depending on the nature of the investment. Sensitivity analysis, Scenario analysis, and Simulation analysis should be compared to find the best way to determine the worth of an investment when required.