5

Simulations
14Presented
/08/2020 by You Exec

ICAR- National Academy of Agricultural Research Management, Hyderabad | https://naarm.org.in/

 What is Monte Carlo Simulation?

Monte Carlo simulation, or probability simulation, is a technique used to

understand the impact of risk and uncertainty in financial, project
management, cost, and other forecasting models.

ICAR- National Academy of Agricultural Research Management, Hyderabad | https://naarm.org.in/

• In Corporate Finance, project finance and real options analysis, Monte
Carlo Methods are used by financial analysts who wish to construct
"stochastic" or probabilistic financial models as opposed to the traditional
static and deterministic models.
• In order to analyze the characteristics of a project’s net present value
(NPV), the cash flow components that are impacted by uncertainty are
modeled, incorporating any correlation between these, mathematically
reflecting their "random characteristics".
• Then, these results are combined in a histogram of NPV (i.e. the project’s
probability distribution), and the average NPV of the potential investment
- as well as its volatility and other sensitivities - is observed. This
distribution allows, for example, for an estimate of the probability that the
project has a net present value greater than zero.

ICAR- National Academy of Agricultural Research Management, Hyderabad | https://naarm.org.in/

 • Would be able to estimate the probabilities of uncertain events.
• Yes and accurately:
• For example, what is the probability that a new product’s cash flows will have a positive
net present value (NPV)?
• What is the risk of our investment portfolio?
• Monte Carlo simulation enables us to model situations that present
uncertainty and play them out thousands of times on a computer.

ICAR- National Academy of Agricultural Research Management, Hyderabad | https://naarm.org.in/

 • Generate random no and work frequency of it?

=RAND()

ICAR- National Academy of Agricultural Research Management, Hyderabad | https://naarm.org.in/

 • Simulate values of normal distribution
• NORMAL Distribution parameters
• Mean
• SD

• We shall take up this with one example

• Let’s suppose we want to simulate 400 trials or

iterations for a normal random variable with a mean of
40,000 and a standard deviation (σ) of 10,000.

=NORMINV(RAND(),mean,sigma)

ICAR- National Academy of Agricultural Research Management, Hyderabad | https://naarm.org.in/

 Business decisions
• How should a greeting card company determine how many
cards to produce?
• Suppose that the demand for a Valentine’s Day card is
governed by the following discrete random variable:

Demand Probability
10,000 .10
20,000 .35
40,000 .3
60,000 .25
ICAR- National Academy of Agricultural Research Management, Hyderabad | https://naarm.org.in/
 • The greeting card sells for $4.00, and the variable cost
of producing each card is $1.50. Leftover cards must
be disposed of at a cost of $0.20 per card.

• How many cards should be printed?

• Basically, we simulate each possible production

quantity (10,000, 20,000, 40,000 or 60,000) many
times (say, 1,000 iterations). Then we determine which
order quantity yields the maximum average profit over
the 1,000 iterations.

ICAR- National Academy of Agricultural Research Management, Hyderabad | https://naarm.org.in/

 Decision in Excel

• The impact of risk on our decision

• If we produce 20,000 cards instead of 40,000 cards, our expected profit drops
approximately 22 percent, but our risk (as measured by the standard
deviation of profit) drops almost 73 percent.
• Therefore, if we are extremely risk averse, producing 20,000 cards might be
the right decision.
• By the way, producing 10,000 cards always has a standard deviation of zero
cards because if we produce 10,000 cards, we will always sell all of them and
have none left over.

ICAR- National Academy of Agricultural Research Management, Hyderabad | https://naarm.org.in/

 Some problems for assignment Individual
• A gold dealer believes that demand for 2005 emerald will be normally
distributed with a mean of 200 and standard deviation of 30. His cost of
receiving an emerald is $25,000, and he sells an emerald for $40,000. Half of
all leftover emerald can be sold for $30,000. He is considering ordering 200,
220, 240, 260, 280, or 300 emerald. How many should he order?
• A small supermarket is trying to determine how many copies of People
magazine they should order each week. They believe their demand for
People is governed by the following discrete random variable.
Demand Probability
15 .10
20 .20
25 .30
30 .25
35 .15
• The supermarket pays $1.00 for each copy of People and sells each copy for
$1.95. They can return each unsold copy of People for $0.50. How many
copies of People should the store order?
ICAR- National Academy of Agricultural Research Management, Hyderabad | https://naarm.org.in/