146 Financial Management
Illustration
In real life situations, simulation is done only on the computer because of the
computational medium involved. However, to give you a flavour of what goes on in
simulation, we will work with a simple example where simulation has been done
manually.
Zenith Chemicals is evaluating an investment project whose net present value has been
modeled as follows:NPV = Annual Cost Flow
t Risk Free Raten
= 1 (+ - )
ñ Initial Investment ...(8.5)In the NPV model embodied in Eq. (8.5), the risk-free rate and the initial investment
are parameters with the following values: risk-free rate = 10 per cent and initial
investment = Rs 13,000. The annual cash flow and the life (n) are stochastic exogenous
variables with the following distributions:
Annual Cash Flow Project Life
Value Probability Value Probability
Rs.
1,000 0.02 3 years 0.05
1,500 0.03 4 0.10
2, 000 0.15 5 0.30
2,500 0.15 6 0.25
3,000 0.30 7 0.15
3,500 0.20 8 0.10
4,000 0.15 9 0.03
10 0.02
The firm wants to perform 10 manual simulation runs for this project. To perform the
simulation runs, we have to generate values, at random, for the two exogenous
variables: annual cash flow and project life. For this purpose, we have to (i) set up the
correspondence between the values of exogenous variables and random numbers, and
(ii) choose some random number generating device. Exhibit 8.10 shows the
correspondence between various variables and two digit random numbers. Exhibit 8.1 1
presents a table of random digits that will be used for obtaining two digit random
numbers.
Now we are ready for simulation. In order to obtain random numbers from Exhibit 8.1 1
we may begin anywhere at random in the table and read any pair of adjacent columns
(since we are interested in a two-digit random number) and read column-wise or row-
wise.
For our example, let us use the first two columns of Exhibit 8.11. Starting 8.11. Starting
from the top, we will read down the column. For the first simulation run we need two-