Using Monte Carlo simulation to make better capital investment decisions

The financial analysis of a proposed capital investment typically involves estimating the project's expected cash flows and profitability and then perhaps looking at one or two alternative scenarios. However, this procedure provides incomplete information about a project's potential risk/return characteristics because it focuses on only a few possibilities; whereas, real-world investments can have an almost unlimited number of financial outcomes. Monte Carlo simulation can solve the incomplete information problem. In a Monte Carlo simulation, relatively certain input variables are specified by single values, while relatively uncertain variables are specified by probability distributions. The end result is a probability distribution that describes the project's full range of potential profitability. With a complete set of information concerning a project's risk/return characteristics, decision makers can better judge the financial impact of the investment and hence make better capital investment decisions.