In considering risky investments, we can use simulation to approximate the expected return for an investment proposal. Thus simulation is one way of dealing with the uncertainty involved in forecasting the outcomes of capital budgeting projects or other types of decisions.
The results of an investment proposal are tested before it actually occurs. Each of the factors affecting the projects NPV are assigned probability distributions. Example of these factors are:
i. Market size
ii. Selling price
iii. Market growth rate
iv. Share of market
v. Cost of the project
vi. Residual value
vii. Operating costs
viii. Fixed costs
ix. Useful life of project
Once the probability distributions are determined, the average rate of return resulting from a random combination of the above nine factors is determined.
A computer can be used to carry out simulation trials for each of the above factors. A simulation model relies on repetition of the same random process as many times as possible.
One of the benefits of simulation is its ability to test various possible combination of events. This sensitivity testing allows the planner to ask "what if" questions.