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# Finance Dictionary - S Terms

# Simulation Analysis

In reality, every variable relevant to the capital budgeting decision can be viewed as a random variable. Scenario analysis and sensitivity analysis limit the randomness aspects of each item by examining only a few values of each variable. Simulation analysis attempts to realistically portray the relevant inputs to the capital budgeting project as random variables. Each variable, whether it be price, variable cost, project life, or some other item, is assumed to have a probability distribution with a known mean and variance. In each simulation trial, computer analysis uses a random number generator to select values from each variable’s probability distribution as the basis for net present value (NPV) calculation. This process is repeated many times; each time, numbers are randomly drawn from each probability distribution. After replicating the trials several thousand times, the statistical distribution of the computed NPVs is plotted, and the average NPV and its variance are computed. Unlike the NPV point estimates derived from scenario or sensitivity analysis, simulation analysis gives an estimated distribution of potential NPVs. Of course, the simulation output is only as accurate as the inputs. It is likely that an inaccurate NPV distribution will result if inappropriate probability distributions, means, and variances are used as inputs.