John Herbohn

Capital Budgeting: Simulation concepts and methods

The term ‘simulation’ is widely used nowadays, and most people have their own view of its meaning. In general, to ‘simulate’ means to mimic or capture the essence of something, without attaining reality. In management applications, simulation typically involves developing a model of a business or economic system, and then performing experiments using this model to predict how the real system would behave under a range of management policies. In that financial models have been used repeatedly in earlier chapters, the importance of modelling will come as no surprise here. But when discussing simulation, attention to aspects of modelling becomes even more important since simulation models are often highly complex representations of business systems. While many quantitative techniques take a well-recognized form, simulation differs in its great flexibility, variety of applications and variations in form. These features, while highly valuable for modelling complex business systems, make this a difficult methodology to explain and to comprehend. In fact, simulation has been described as ‘more art than science’. Proficiency with this technique cannot readily be gained in the classroom. Considerable hands-on experience from repeatedly designing, developing and performing experiments with a number of different models is also necessary. But even for readers who will not be engaged in developing complex models, an understanding of simulation concepts is indispensable because of the widespread use of this methodology. The financial models encountered in earlier chapters, typically developed on a spread-sheet, may be regarded as a form of simulation.

Capital Budgeting: Project analysis under risk

The previous chapter discussed project analysis under certainty, i.e. in a no-risk situation. In reality, however, the future cash flows of a project are not certain. Cash flows cannot be forecast with absolute accuracy. These are estimates of what is expected in the future, not necessarily what will be realized in the future. Sometimes, even the initial capital outlay can be uncertain and subject to high estimation errors. For example, in 1987 the cost of the Channel Tunnel (between Britain and France) was estimated to be

Capital Budgeting: Project analysis under certainty

12 billion, but later this was increased to about

Capital Budgeting: Forecasting cash flows: quantitative techniques and routes

22 billion. The Sydney Opera House is another famous example of a large cost increase over the initial estimate. In the previous chapter, one single series – the best estimate of the projects future cash flows – was used to compute the net present value. This series may be viewed as the best estimate of a range of possible outcomes. For example, in Chapters 2 and 6, the Delta Project was considered and its first years sales were expected to be

Sustainable small-scale forestry : socio-economic analysis and policy

345,553. This was the best estimate. But this amount could eventually prove to have been under or over the actual sales that the project generated. This sales forecast was arrived at by estimating the sales units on the basis of past sales and assuming a unit selling price of

Tree farming in the Philippines: some issues and recommendations.

0.50. However, the actual selling price might be different to this forecast value.

Understanding forest transition in the Philippines: main farm-level factors influencing smallholder's capacity and intention to plant native timber trees

In the previous chapters, we have discussed the identification and estimation of project cash flows and illustrated the mathematical formulae essential for project evaluation. This chapter now uses these elements for investment analysis. There are two groups of project evaluation techniques: discounted cash flow (DCF) analysis and non-discounted cash flow (NDCF) analysis. The first group includes the net present value (NPV) and the internal rate of return (IRR). The second group includes the payback period (PP) and the accounting rate of return (ARR). Generally, DCF analysis is preferred to NDCF analysis. Within DCF analysis, the theoretical and practical strengths of NPV and IRR differ. Theoretically, the NPV approach to project evaluation is superior to that of IRR. The NPV technique discounts all future project cash flows to the present day to see whether there is a net benefit or loss to the firm from investing in the project. If the NPV is positive, then the project will increase the wealth of the firm. If it is zero, then the project will return only the required rate of return, and will not increase the firms wealth. If the NPV is negative, then the project will decrease the value of the firm and should be avoided. In spite of the theoretical superiority of the NPV technique, project analysts and decision-makers sometimes prefer to use the IRR criterion. The preference for IRR is attributable to the general familiarity of managers and other business people with rates of return rather than with actual dollar returns (values).

Capital Budgeting: Property investment analysis

Forecasting is important in all facets of business. A supermarket needs to forecast the demand for different types of cleaning agents, soft drinks and meat products. A car manufacturer has to forecast the demand for the different types of cars it produces. A farmer must forecast the demand for a variety of crops when deciding what to plant next spring. A government must forecast its tax revenue in order to design its budget each year. A business corporation needs to forecast the future requirement of different types of labour inputs, raw materials, machines and buildings as an integral part of its business processes. All business firms have to plan for the future. The success of a business firm is closely related to how well management is able to anticipate the future and develop suitable strategies. No business organization can function effectively without forecasts for the goods and services it provides and the inputs it purchases. In project evaluation, the ‘cash flows’ of a proposed project refer to expected future cash flows of that project. The reference is not to past or historical data, but to future data expected from the proposed project. Perhaps the most critically important task in project appraisal is the forecasting of expected cash flows. The cash flows form the basis of project appraisal. If the cash flow estimates are not reliable, the detailed investment analyses can easily lead, regardless of the sophisticated project appraisal techniques used, to poor business decisions.