Monte carlo simulation in capital budgeting

hapter 10 project analysis, best practice in capital budgeting

23. Monte Carlo simulation Look back at the guano project in Section 6-2. Use the Crystal Ball'

software to simulate how uncertainty about inflation could affect the project's cash flows.

Waldo County

Waldo County, the well-known real estate developer, worked long hours, and he expected his staff to do the same. So George Chavez was not surprised to receive a call from the boss just as George was about to leave for a long summer's weekend.

Mr. County's success had been built on a remarkable instinct for a good site. He would exclaim "Location! Location! Location!" at some point in every planning meeting. Yet finance was not his strong suit. On this occasion he wanted George to go over the figures for a new $90 million outlet mall designed to intercept tourists heading downeast toward Maine. "First thing Monday will do just fine," he said as he handed George the file. "I'll be in my house in Bar Harbor if you need me."

George's first task was to draw up a summary of the projected revenues and costs. The results are shown in Table 10.8. Note that the mall's revenues would come from two sources: The com¬pany would charge retailers an annual rent for the space they occupied and in addition it would receive 5% of each store's gross sales.

Construction of the mall was likely to take three years. The construction costs could be depre¬ciated straight-line over 15 years starting in year 3. As in the case of the company's other develop¬ments, the mall would be built to the highest specifications and would not need to be rebuilt until year 17. The land was expected to retain its value, but could not be depreciated for tax purposes.

Construction costs, revenues, operating and maintenance costs, and real estate taxes were all likely to rise in line with inflation, which was forecasted at 2% a year. The company's tax rate was 35% and the cost of capital was 9% in nominal terms.

George decided first to check that the project made financial sense. He then proposed to look at some of the things that might go wrong. His boss certainly had a nose for a good retail project, but he was not infallible. The Salome project had been a disaster because store sales had turned

Year

0 I 2 3 4 5-17

Investment

Land 30

Construction 20 30 10

Operations:

Rentals 12 12 12

Share of retail sales 24 24 24

Operating and maintenance costs 2 4 4 10 10 10

Real estate taxes 2 2 3 4 4 4

TABLE 10.8 Projected revenues and costs in real terms for the Downeast Tourist Mall (figures in $ millions).

out to be 40% below forecast. What if that happened here? George wondered just how far sales could fall short of forecast before the project would be underwater.

Inflation was another source of uncertainty. Some people were talking about a zero long-term inflation rate, but George also wondered what would happen if inflation jumped to, say, 10%.

A third concern was possible construction cost overruns and delays due to required zoning changes and environmental approvals. George had seen cases of 25% construction cost overruns and delays up to 12 months between purchase of the land and the start of construction. He decided that he should examine the effect that this scenario would have on the project's profitability.

"Hey, this might be fun," George exclaimed to Mr. Waldo's secretary, Fifi, who was heading for Old Orchard Beach for the weekend. "I might even try Monte Carlo."

"Waldo went to Monte Carlo once," Fifi replied. "Lost a bundle at the roulette table. I wouldn't remind him. Just show him the bottom line. Will it make money or lose money? That's the bot¬tom line."

"OK, no Monte Carlo," George agreed. But he realized that building a spreadsheet and run¬ning scenarios was not enough. He had to figure out how to summarize and present his results to Mr. County.

QUESTIONS

1. What is the project's NPV, given the projections in Table 10.8?

2. Conduct a sensitivity and a scenario analysis of the project. What do these analyses reveal about the project's risks and potential value?