226 Corporate Finance
We can define multiple assumptions and forecasts. Once that is done, the Crystal Ball command or toolbar
icon can be used to run a simulation. For each trial in this simulation, Crystal Ball enters a random value into
the ‘Marketing Cost’ cell based on the values we used to define the triangular distribution. For trial No. 1, the
random value might be $15,000,000, followed by $17,500,000 for trial No. 2, $16,875,000 for trial No. 3...
and so on. Each time Crystal Ball enters a random value, it recalculates the spreadsheet and saves the
forecast value in its memory for analysis later. If we run a simulation for 5,000 trials, then we have created
5,000 forecasts (or possible outcomes), compared to the single outcome you started with in the deterministic
spreadsheet. Simulation results are displayed in interactive histograms, or frequency charts. The given chart
shows the results of 5,000 trials of ‘Net Profit’.
Note that the range of possible net profit values is $6,300,000 to $11,100,000, with a mean (average)
value of $8,800,000. There is only a 38 percent certainty that we receive a net profit of $9,200,000 as we
originally predicted.
Source: Decisioneering.
INCORPORATING RISK INTO CAPITAL BUDGETING DECISIONS
There are two ways of incorporating risk into capital investment appraisal. One way is to adjust the discount
rate to reflect the riskiness of the cash flow and the other approach is to adjust the cash flow for risks and use
a risk free rate as discount rate.
Adjusting Discount Rate
The discount rate is adjusted to reflect the riskiness of the project cash flows. The risk-adjusted discount rate
is arrived at by adding suitable risk premiums to a risk free rate of return to adjust the discount rate for each
factor contributing to the riskiness of the project. The higher the risk, the higher is the discount rate. Modern
finance theory tells us that only systematic risk (as measured by beta of the stock) is relevant since all other
forms of risk could be diversified away. Thus,