Capital

Budgeting
and Risk
(Simulation Analysis,
Decision Tree, Real
Options, Global
Application)
Bryan B. Viloria

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 Monte Carlo simulations are used to model the
probability of different outcomes in a process that
cannot easily be predicted due to the intervention of
random variables. It is a technique used to
Simulation understand the impact of risk and uncertainty in
prediction and forecasting models.
Analysis Managing Risk
(Monte Manipulating data enables you to examine how
much you can invest or afford to lose under
Carlo certain simulated circumstances. By supplying
numbers representing uncertain inputs (such as
Simulation) revenue and prices), you can track potential
output and results. For example, you can simulate
cash flow, estimate return rates and risk of new
product introductions, determine the risk of
exchange rate fluctuations or determine investment
strategies.

Monte Carlo simulations are named after a popular gambling destination in Monaco

The technique was developed by Stanislaw Ulam andJohn Von Neumann

While recovering from a brain surgery, Ulam entertained himself by playing countless games of solitaire. He became
interested in plotting the outcome of each of these games in order to observe their distribution and determine the
probability of winning. After he shared his idea with John Von Neumann, the two collaborated to develop the Monte
Carlo simulation.

Although the sensitivity and scenario analysis techniques are popular with business, they do not make use of
probability distributions.

One way to measure or assess the operating characteristics of a system is to observe that system in actual
operation. However, in many types of situations, the cost of direct observation can be very high.
Furthermore, changing some of the relationships or parameters within a system on an experimental basis
may mean waiting a considerable amount of time to collect results on all the combinations that are of
concern to the decision maker. (Mahal at Matagal ang pangobserve)

So to address much of this concerns, simulation analysis is applied.

Also known as multiple probability simulation.

The Manhattan Project was a research and development undertaking during World War II that
produced the first nuclear weapons. It was led by the United States with the support of the United
Kingdom (which initiated the original Tube Alloys project) and Canada.

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 The basis of a Monte Carlo simulation is that the
probability of varying outcomes cannot be determined
because of random variable interference. Therefore, a
Monte Carlo simulation focuses on constantly
repeating random samples to achieve certain
results.
p 11.81 p ri ce per unit
q 2, 321.82 n umber o f units sol d
c 2.37 u nit produc tion c ost (excl udin g de pre ciati on)
s 1 u nit s ell ing cos t
D 2, 000.00 annual depreci ati on
T 40% fi rm' s margi nal tax rate
k 10% req uired rate of return

p q c
mean 10.00 2,000.00 2.00
StDev 2.00 300.00 0.25

Year Amount Tax Effect After-tax Net Cash Fl ow

now (10,000.00) 1 (10, 000.00) Ini tial Investment
1 17,604.00 60% 12, 562.40 {[(Number of Units So ld)x(Price per Un it-Uni t Producti on Cos t-Uni t Sel l ing Cost)]-A nnual Depreci ati on}*(1-tax rate)
2 17,604.00 60% 12, 562.40
3 17,604.00 60% 12, 562.40
4 17,604.00 60% 12, 562.40
5 17,604.00 60% 12, 562.40 Frequency
NPV 37,621.39 40

35
Interatio n NPV
37,621.39 30
1 33,666.69 NPV Fre quency
25
2 21,146.10 - 1
3 17,689.25 10,000.00 0 20
4 21,061.30 20,000.00 37
5 31,632.61 30,000.00 34 15
6 17,979.85 40,000.00 20
10
7 40,656.64 50,000.00 7
8 19,944.23 >50, 000.00 1 5
9 19,881.15 100
0
10 42,810.64 - 1 0,00 0.00 20 ,000 .00 30, 000. 00 40,0 00.0 0 5 0,00 0.0 0 >5 0,00 0.00
11 28,557.10
12 22,602.91
13 33,151.42
14 19,366.55
15 10,647.18
16 (2,762.80)
17 31,262.94
18 50,831.50
19 30,180.58
20 29,705.98
21 25,655.02
22 21,196.25
23 24,940.02
24 31,087.00
25 14,808.53
26 17,393.66
27 17,606.19
28 13,921.83
29 22,787.92
30 38,886.28
31 16,550.38
32 14,186.95
33 12,633.53
34 30,469.08
35 11,677.30
36 18,494.49
37 27,155.25
38 25,111.33

Simulation analysis are usually conducted in a computerized environment. Some uses a specialized
program to perform the operation.

A Monte Carlo simulation takes the variable that has uncertainty and assigns it a random value. The model
is then run and a result is provided. This process is repeated again and again while assigning the variable
in question with many different values. Once the simulation is complete, the results are averaged
together to provide an estimate.

So to demonstrate,

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 A decision tree is a managerial tool
that presents all the decision
alternatives and outcomes in a
flowchart type of diagram, like a
tree with branches and leaves. Each
branch of the tree represents a
Decision decision option, its cost and the
probability that it is likely to occur. The
Trees leaves at the end of the branches
show the possible payoffs or
outcomes. A decision tree illustrates
graphically all the possible
alternatives, probabilities and
outcomes and identifies the
benefits of using decision analysis.

One other method for making decisions under conditions of risk is the decision tree.

This technique is especially suitable when decisions have to be made sequentially.

The algorithm of a decision tree can be integrated with other management analysis tools such as Net
Present Value and Project Evaluation Review Technique (PERT).

Comprehensive. It forces the consideration of all possible outcomes of a decision and traces each path to
a conclusion. It creates a comprehensive analysis of the consequences along each branch and identifies
decision nodes that need further analysis.
Specific. Decision trees assign specific values to each problem, decision path and outcome.
Easy to Use. Decision trees are easy to use and explain with simple math, no complex formulas.
Versatile. They are useful tools for business managers, technicians, engineers, medical staff and anyone
else who has to make decisions under uncertain conditions.

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In designing your decision tree, consider these flow chart symbols.
Box representing Decision
Circle denoting option is unclear
Lines for alternatives
And a triangle to indicate the endpoint

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How to Make a Decision Tree?
1. To make a decision tree, start with a specific decision that needs to be
made. You can draw a small square at the far left of the eventual tree to
represent the initial decision.
2. Draw lines outward from the box; each line moves from left to right,
representing a potential option. Alternatively, you can start with a square
at the top of a page or screen, and draw the lines downward.
3. At the end of each line or option, analyze the results. If the result of an
option is a new decision, draw a box at the end of that line, and then
draw new lines out of that decision, representing the new options, and
labeling them accordingly. If the result of an option is unclear, draw a
circle at the end of the line, which denotes potential risk. If an option
results in a decision, leave that line blank.
4. Draw a triangle to indicate the endpoint.
You continue to expand until every line reaches an endpoint,
meaning you've covered every choice or outcome.

We need to decide whether to build a game, build productivity app, or revamp

existing app.

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 Real Options in Capital Budgeting
The ability to make changes is commonly referred to as real options that
are embedded in the capital project. Real options include the decision to
expand, defer or wait, or abandon a project entirely.

These real options may increase the value of a project above that resulting
from a straightforward discounted cash flow calculation.

Value of the project = NPV + option value

The value of the option is the difference between the project’s value with and
without the option.

In analyzing capital budgeting decisions, we made estimates of costs, cash flows, life of the project, and probabilities
of outcomes, and then proceeded to
calculate the NPV or the IRR.

But we did not consider that there might be an opportunity for making changes in some aspects of the project while it
is in progress or to
make adjustments even before the project is started, thus real options in capital budgeting comes into place.

Real options in capital budgeting allows managers or a company to make some changes or alter their cash flow
decision when the opportunities come. This means that manager or company is able to make improved and more
strategic decisions by considering the economic impact as a result of any contingent actions on the capital project
cash flow and associated risk.

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 There Option to vary output.
are
various Option to vary inputs—flexibility.
forms
of real Option to abandon.
options:
Option to postpone.

Option to introduce future products.

Options to vary output (Altering the Number of Production): Some projects can be structured to permit operations
to expand if demand rises above expectations (this is usually called a growth option), or to contract operations if
demand falters. It may even allow for a temporary shutdown of production.

In relation to companies during an economic recession (pandemic), many companies are forced to reduce their
capacity as they predict that customers behavior will shift negatively or unfavorably.

Option to vary inputs—flexibility (Alternatives to reduce costs). A plant may include the possibility of operating with
different types of fuel. Although the original cost of the plant may be higher, switching from a more expensive fuel to
a less expensive one may make the project more. favorable. Another potential flexibility is that of taking advantage of
different technologies, depending on input costs. This is not restricted to fuel; for example, the same could be said of
a processed-food manufacturer who substitutes various sweetening inputs based on price.

Option to abandon (Discontinuing unviable projects). If, after the project has been started, results turn sour, it is
possible that abandoning the project will improve its payoff. If the project can be sold for a price higher than the
present value of its expected cash flows, or if its facilities can be used more favorably in another part of the company,
then abandoning the project will enhance its value.

Option to postpone (Perfect timing). An oil company may profit by postponing the extraction of oil from its field if
current prices are low but are expected to rise in the future. A company may postpone the introduction of a new
product pending completion of market research to better evaluate the product’s potential. The same analysis applies
to any company extracting nonrenewable natural resources.

It can be associated to hoarding. Hoarding is the purchase and warehousing of large quantities of a commodity by a
speculator with the intent of benefiting from future price increases.

Option to introduce future products (Positive expectation or outlook regardless of current conditions). A company
may be willing to launch a product with a negative NPV if doing so gives it an option to gain an advantage when later

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versions of the product are introduced.

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 Political Risk

When expanding globally, companies may be confronted by political risk.

1. changes in taxes, labor law rules, minimum wages, and price controls.
2. Restrictions on the repatriation of dividends, special labor conditions, tariff and nontariff barriers, and also
imposition of administrative rules (red tape)
3. A government takes over foreign property, usually with the intention of operating the business itself. Expropriation
can be done with fair compensation and with inadequate or no compensation. (power of eminent domain)
4. These can lead to destruction of a firm’s property. (Israel and Palestine conflict, US Vs. Iraq)

Repatriation refers to converting any foreign currency into one’s local currency.

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End 

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