Computer Simulation in Financial Risk Management: A Guide for Business Planners and Strategists

The ranking of projects is usually in terms of reward with little regard to risk. The use of simulation and the adjustment of the escrow account permit projects to be ranked by reward for a given level of risk. This should place managers in a better position to select those projects that should be funded and those that should be shelved. A general purpose simulation program could be written containing the principles described here. Management would enter assessments of the most likely values, and the limits on the range of values, for the key variables along with a maximum negative balance in the escrow account to separate insolvency from bankruptcy. The program would determine an initially funded escrow account that satisfies the corporate objective on risk. The funding of the escrow account becomes part of the capital commitment of the project. Projects can then be ranked by reward for the given specification of risk.

Is management better off having this additional information when making decisions on which projects to fund? Only management can answer this.

The program in this appendix was used to derive the financial risk profile for the proposed plastics goods factory. It is a special purpose program designed for this application. A general purpose program would contain the essential elements of this program.

SIMONE was run to generate the cost overrun distribution and was renamed OVER. SIMONE was then run six times to generate the various distributions associated with good and bad times in the plastics business as described in the chapter. These simulators are fed into the program in statements 40 to 170. The arrays for weeks of fad plastic production and weekly gross income for fad and nonfad plastic production are two row arrays, where the first row is applicable to the good times and the second row is applicable to the bad times. Statements 180 to 200 provide a 50-50 opportunity for the plastics plant to start off with good times or bad. This is indicated by assigning a value of I or 2 to the Z variable. This determines which row of the aforementioned arrays is to be referenced. Statement 210 assigns a value between 2 and 5 to the variable H that determines how long the good or bad times will last. Variable H1 is the counter keeping track of the length of good and bad times during the simulation run.

The two thousand simulations start in statement 220 with the selection in statement 230 of the cost overrun, the determination of annual depreciation, and the capitalized cost for each individual simulation. The variable U in statement 240 is the maximum balance in the escrow account. The twenty-year cash flow projection for each simulation starts in statement 250, with the duration of the successive good and bad times being determined in statements 260 to 300. Annual gross margin is determined in statements 310 to 320 by multiplying the weeks of fad and nonfad plastic production by the respective weekly gross margins and summing the two. Fixed operating costs are established in statements 330 to 350. Before tax income is calculated in statement 360, and statements 370 to 430 handle whether taxes are payable or not and the accruing of tax losses.

The net cash flow is calculated in statement 440 with provision for adjustment during the twentieth year for the project's residual value (statement 450) and the liquidation of the escrow account (statements 520-540). The interplay between the escrow account and the payout to equity investors is performed in statements 460 to 540. Statements 470 and 480

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