Monte Carlo Simulation – Financial Models | NPV Examples Outline

Simulation applied to NPV applications

Example: NPV of Uncertain, After-Tax Cash Flows

(Example 12.5, Developing A New Car at GF Auto, Winston and Albright, PMS, 3ed.)

General Ford (GF) Auto is developing a new model of compact car.

This car is assumed to generate sales for the next five years. GF has
gathered information about the following quantities through focus
groups with the marketing and engineering departments:

Fixed cost of developing car. This cost is assumed to be $1.4 billion.

The fixed cost is incurred at the beginning of year 1, before any sales
are recorded.

Margin per car. This is the unit selling price minus the variable cost of
producing a car. GF assumes that in year 1, the margin will be
$5,000. Every other year, GF assumes the margin will decrease by
4%.

Sales. The demand for the car is the uncertain quantity. GF assumes
sales – number of cars sold – in the first year are triangularly
distributed with parameters 100,000, 150,000, and 170,000. Every
year after that, the company assumes sales will decrease by some
percentage, where this percentage is triangularly distributed with
parameters 5%, 8% and 10%. GF also assumes the percentage
decreases in successive years are independent of one another.

Depreciation and taxes. The company depreciates its development

cost on a straight-line basis over the lifetime of the car. The corporate
tax rate is 40%.

Discount rate. GF figures its cost of capital at 15%.

Objective. Develop a simulation model to examine NPV of after-tax

cash flows for this new car over the 5-year time horizon.

The following model can be developed:

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Monte Carlo Simulation – Financial Models | NPV Examples Outline

Unit sales:
B12 is defined as an “assumption” cell with parameters entered from
cells E5 (min), F5 (most likely) and G5 (max).

B14: =B12

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Reduced sales in later year (beginning in C14):

=B14*(1- Annual decay rate entered as triangular distributions in cells
C13:F13 row)

For example, the decay rate is a triangular distribution entered in cell

13 as shown. We go through the same process in creating assumption
cells in D13:F13, all referring back to E6, F6 and G6 for their
parameters.

Contributions:
B15: =B5 | C15 (and across): =B15*(1-$B$6)

Row 16: =product of rows 14 and 15

Depreciation:
Row 17: =B4/5 for each year

Before tax profit:

Subtract depreciation from total contribution.
Row 18: = row 16 – row 17

After tax profit:

Multiply before-tax profit by 1 minus the tax rate in B7.
B19: =B18 * (1-$B$7), and copy across row

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Monte Carlo Simulation – Financial Models | NPV Examples Outline

Cash flow:
Sum of corresponding values in rows 17 and 19 (add deprecation back
to get cash flow)
B20: =B17 + B19, and copy across

NPV:
=-B4 + NPV(B8,B20:F20)

Final Actions:

Identify the forecast cell (B22).

Set run preferences.
Run simulation with 1000 trials.

Discussion of Simulation Results:

Showing mean NPV of about $129 million (Preferences | Chart to turn

on “mean” line).

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Monte Carlo Simulation – Financial Models | NPV Examples Outline

On the other hand, entering a “0” in the left box:

We see about an 83% chance of a positive NPV, which implies about a

17% chance of a negative NPV.

We can also look at the 5th percentile, often called the value at risk,
VAR, and see it is about a $95 million loss.

Sensitivity:

We can also look at what is causing the variability in NPV.

Run | Run Preferences | Options:

Select: “Store assumption values for sensitivity analysis”

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Monte Carlo Simulation – Financial Models | NPV Examples Outline

Run Simulation.

Choose Analyze > Sensitivity Charts.

Click on New. Select forecast.

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Monte Carlo Simulation – Financial Models | NPV Examples Outline

Example: Valuation | Problem 12-17

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Monte Carlo Simulation – Financial Models | NPV Examples Outline

Example: Capital Budgeting

(from Charnes (2007) chapter 7 based on example in chapter 10, Brealey, Meyers,
and Allen (2006).

Otobai Company is considering the introduction of an electrically

powered motor scooter for city use. The inputs to be varied and their
base case values are shown in cells A4:B8.

These values are: market size, market share, unit price (yen), unit
variable cost (yen), and fixed cost (billions yen).

Model relationships are:

Investment = 15 billion yen

Revenue = Market size * Market share * Unit price
Variable Cost = Market size * Market share * Unit variable cost
Depreciation = Investment / 10
Pretax profit = Revenue – Variable cost – Fixed cost – Depreciation
Tax = 0.5 * Pretax profit
Net profit = Pretax profit – tax
Operating cash flow = Net profit + depreciation

Assume triangular distribution for assumptions.

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Monte Carlo Simulation – Financial Models | NPV Examples Outline

Results

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Tornado Chart Tool

Select: Add Assumptions

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Example: Reliability | Problem 12-19

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