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198 Applying simulation to decision problems
briefly discuss the commonly used net present value (NPV) approach
to investment appraisal and then show how Monte Carlo simulation
can be used to improve on the ‘standard’ NPV method, which is based
on single-figure estimates of cash flows. We also show that the NPV
method makes some very strong assumptions about the nature of the
decision maker’s preferences, which in some circumstances may not
be justified.
The net present value (NPV) method
Our intention here is to give only a brief overview of the net present
value method. More detailed explanations can be found in accountancy
textbooks (e.g. Besley et al. 5 and Drury 6 ).
When money is invested in a project a commitment of funds is
generally required immediately. However, the flow of funds earned by
the investment will occur at various points of time in the future. Clearly,
receiving $1000 in, say, a year’s time is less attractive than receiving
$1000 now. The $1000 received now could be invested, so that in a year’s
time it will have earned interest. Similarly, $1000 due to be received in
2 years’ time will be less attractive than $1000 which will be received
one year from now. This implies that money which will be earned in the
future should be discounted so that its value can be compared with sums
of money which are being held now. The process involved is referred
to as ‘discounting to present value’. For example, we might judge that
the $1000 due in one year is only equivalent to receiving $909 now,
while the $1000 due in 2 years has only the same value as receiving
$826 now.
The severity with which we discount future sums of money to
their present value is reflected in the discount rate. Determining the
appropriate discount rate for a company’s potential investment projects
is, ultimately, a matter of judgment and preference. However, many
attempts have been made to make the choice of a discount rate as ‘objective’
as possible, making this a complex area which is beyond the scope
of this text. For many situations, it will be convenient to let the discount
rate reflect the opportunity cost of the capital which is being invested
(i.e. the rate of return which could be earned on the best alternative
investment). Thus if we are only considering two mutually exclusive
projects A and B and we could earn a 12% return on project A, then the
discount rate for project B would be 12% because, if we invest in B, we
will be forgoing the 12% return which A would have generated. Having
determined the appropriate discount rate, the process of discounting