ROI ANALYSIS WITH MONTE CARLO SIMULATION

A capital investment project is not a black box but its outcome depends on several factors, some more relevant than others. Smart decision makers want to know what makes a project tick, so they can reduce the uncertainty about its results. They may then run another market research to reduce doubts about customer acceptance of a new service or modify a product spec to reduce manufacturing costs.

This ROI analysis helps you to identify these relevant investment drivers with risk analysis, Monte Carlo simulation, and sensitivity analysis. The tool comes with ready-to-use templates and doesn’t require any statistics background. And FinanceIsland’s tutorials provide an overview of the corporate finance and statistics concepts used in the ROI analysis.

More than just one number

 Rather than providing a single return on investment figure, like the standard ROI analysis shown on the left below, this advanced ROI analysis returns a range of possible outcomes (shown on the right), together with the probability of their occurrences.

As a result, you can model possible outcomes of NPV by modifying its drivers, e.g., sales volume, unit price, or investment expenses. The ROI analysis shows not just whether an investment will be profitable, but how likely it is to be profitable and how profitable it is likely to be. The chart below for example, reveals that there is a 30% chance that this particular investment will lose money.

What standard NPV doesn't tell you

Risk analysis

 Our ROI tool offers you the option of using a project-specific risk-adjusted discount rate in the NPV calculation. The discount rate in the NPV analysis is usually a proxy for the financial risk associated with cash flows of the project. Hence, the discount rate should be project-specific.

The tool provides a framework for deriving a project-specific discount rate by leveraging the ideas of the Capital Asset Pricing Model (CAPM). The ROI analysis applies a user-friendly risk matrix to translate your project's risk into an appropriate discount rate. To find out more about project risk, discount rate, and CAPM, please consult our risk and CAPM tutorial.

Easy-to-use Monte Carlo simulation

 The range of possible NPV outcomes is determined using Monte Carlo simulation. Monte Carlo simulation is basically an enhanced scenario analysis. But unlike typical scenario analyses that allow you to analyze the impact of changing one variable at a time, Monte Carlo simulation lets you analyze all possible combinations at the same time.

Also, in a typical scenario analysis, you need to manually calculate as many scenarios as you deem necessary. Monte Carlo simulation, on the other hand, calculates these scenarios automatically based on your definition of simulation parameters.

Until now the problem with using Monte Carlo simulations has been that existing simulation software packages require extensive knowledge of and experience with underlying statistical concepts. They also require time to first develop financial spreadsheet models and then define Monte Carlo simulation inputs and outputs in those spreadsheets.

FinanceIsland’s ROI tool, on the other hand, already comes with an easy-to-use and standardized template useful for typical NPV analyses, including R&D and marketing investments.

To find out more about Monte Carlo simulation, please consult our Monte Carlo simulation tutorial.

Sensitivity analysis

Not all investment drivers are equal. Some are more relevant than others for the financial success or failure of the investment project. Smart decision makers pay particular attention to these relevant drivers.

The ROI analysis provides a sensitivity chart, referred to also as Tornado chart, to identify the relevant investment drivers. The sensitivity chart shows how much NPV is impacted by each of the NPV components. This allows you to focus on the key drivers to fine-tune your Monte Carlo simulation, so you can reduce the uncertainty about the project outcome even more.

The ROI analysis is currently in the final development stage and we will be available soon.