Capital Budgeting Simulation

Using Excel: Enhancing the

Discussion of Risk in Managerial
Accounting Classes
By Sylwia Gornik-Tomaszewski, DBA, CMA, CFM

EXECUTIVE SUMMARY any leading managerial accounting textbooks

An Excel-based capital budgeting
simulation model that contains a
degree of randomness and uncertainty
can be used to expand classroom
discussions of risk in the context of
capital investment analysis. This adds
M provide only limited coverage of risk in the
a level of detail that is often over-
looked by most managerial accounting
textbooks.
context of capital budgeting, often referred
to as capital investment analysis. Capital
budgeting chapters usually focus on widely
used decision models, such as net present value (NPV), inter-
nal rate of return (IRR), accounting rate of return (ARR),
profitability index (PI), and the payback period (PB), and are
often enhanced with analyzing tax implications in capital bud-
geting decisions.1 But only the deterministic versions of these
models, in which no randomness is involved, are covered.
Cash flows are forecasted as single figures, and their uncer-
tainty is ignored. The risk associated with an investment proj-
ect is expressed in the selected discount rate (required rate of
return). The lesson being told, therefore, is that the greater
the risk that is associated with an investment, the greater the
return that is required.
In practice, however, several different techniques are used
to deal with the uncertainty of investment projects. Firms
might combine NPV with PB when analyzing the total risk of
a project. They also might use sensitivity analysis, scenario
analysis, risk-adjusted discount-rate approach, or simulation.

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These techniques are applied following the assumption
that it is relevant to consider a projects total risk when
evaluating the project and when the returns from the
project are positively correlated with the returns from
the firm as a whole.2
Although the leading textbooks do not delve into
these methods for dealing with uncertainty in invest-
ments, the techniques can be explained easily in the
classroom, especially when supplemented with spread-
sheet applications. An educational model developed in
Excel can provide a simple simulation of the NPV of an
investment project whose outcome is uncertain. The
model is easy to use, requiring only a basic Excel pack-
age and not the @Risk add-in.
Basic Simulation Model
A simulation model is a computer model that imitates a
real-life situation. When applicable in capital budgeting,
the simulation approach generally is more feasible for
analyzing large projects because the technique requires
estimates to be made of the probability distribution of
each cash flow element.
Simulation uses random numbers to drive the model-
ing process. All spreadsheet packages are capable of
generating random numbers between 0 and 1. In Excel,
random numbers are generated by entering the formula
=RAND() in a cell. The random numbers are uniformly
distributedthat is, any number between 0 and 1 has
the same chance of occurrence. Also, different random
numbers generated in one spreadsheet are probabilisti-
cally independent, meaning the random value in one
cell does not affect random values in other cells.3
It is critical to understand that flux is an important
characteristic of simulation. We will have to get accus-
tomed to constantly changing numbers because all the
cells containing the RAND function will change each
time we press the recalculate key (F9) or do anything to
affect calculation.
Figure 1 presents a simple capital budgeting model
involving the introduction of a new product. We will
need to determine annual after-tax cash flows generated
by the new product. Therefore, the first step in devel-
oping the model is to enter the relevant data needed to
compute these cash flows. This includes data to deter-
mine revenues, costs, depreciation, and marginal tax
M A N A G E M E N T A C C O U N T I N G Q U A R T E R LY
rate. Also needed is the firms required rate of return to
discount the after-tax net cash flow to present value.
Rows 5 to 15 of the spreadsheet contain assumed data
on price per unit (p), number of units sold (q), unit pro-
duction cost (c), unit selling cost (s), annual depreciation
(D), the firms marginal tax rate (T), and the firms re-
quired rate of return (k).
To build uncertainty into the model, assume that the
first three variablesp, q, and care random (stochas-
tic) in nature. This requires an estimation of the proba-
bility distribution for each of these random variables.
Although a discrete distribution could be used with a
finite, relatively small number of possible values with
known probabilities, it is more convenient to use con-
tinuous distributions in a simulation. The RAND func-
tion in Excel generates various continuous distributions
commonly used in applications. Assume that the three
random variablesp, q, and care normally distributed.
Cells C14:E15 contain the mean () and standard devi-
ation () for each of the three random variables. As you
can see in Figure 1, the price per unit (p) is normally
distributed with = $10 and = $2; the number of
units sold (q) is normally distributed with = 2,000 and
= 300; and the unit production cost (c) is normally dis-
tributed with = $2 and = $0.25. These small num-
bers are selected on purpose to make the model easy to
understand. Users of the model can use their own
prices, costs, quantities, and determine distributions of
these numbers. It is suggested, however, that certain
basic rules should apply, such as assuming p>c and
<, to avoid complications that obscure the purpose
and focus of this exercise.
With those assumptions, applying the Excel function
=NORMINV(RAND(),,) will generate random val-
ues for p, q, and c based on normal distribution. For ex-
ample, the formula =NORMINV(RAND(),C14,C15) in
cell C5 generates the random price per unit (p) from a
normal distribution. The values for q and c are gener-
ated in a similar manner from their respective means
and standard deviations.
Now that the data inputs are defined, the next step is
to build the NPV model, seen in cells A17:E26 of
Figure 1. The model assumes that (1) the initial invest-
ment necessary to introduce the new product is $10,000
(cell C20), (2) the new product will have a life of five
13 SUMMER 2014, VOL. 15, NO. 4
 Figure 1: Capital Budgeting with Simulation

A B C D E F G H
1
2 CAPITAL BUDGETING WITH SIMULATION
3 Data:
4
5 NCF p 10.16 price per unit
6 q 2,292 number of units sold
7 c 2.04 unit production cost (excluding depreciation)
8 s 1 unit selling cost
9 D 2,000 annual depreciation
10 T 40% the firm's marginal tax rate
11 k 10% required rate of return
12
13 p q c
14 Mean: 10 2,000 2
15 StDev: 2 300 0.25
16
17 The NPV Determination:
18 A f e r - ta x
19 Item Year (t) Amount T ax E ffec t NCF t
20 Investment now (10,000) 1 (10,000)
21 1 14,311 60% 10,587
22 2 14,311 60% 10,587
23 3 14,311 60% 10,587
24 4 14,311 60% 10,587
25 5 14,311 60% 10,587
26 NPV $30,132
27
28 Simulation:
29
30 Iteration NPV Frequency table for 100 iterations
31 $30,132.07 N PV Frequency
32 1 $30,450.64 0 0
33 2 $20,031.96 10,000 8
34 3 $33,898.81 20,000 30
35 4 $14,301.81 30,000 30
36 5 $34,231.82 40,000 27
37 6 $19,130.41 50,000 4
38 7 $31,494.15 >50,000 1
39 8 $28,536.55 100
40 9 $38,796.87
41 10 $30,653.14
131 100 $15,188.38
132 Mean $24,329.62
133 StDev $10,808.35
134 Min $1,537.28

years (rows 21-25), and (3) no additional investments
will be required during the product lifespan. These as-
sumptions make the annual after-tax cash flows gener-
ated from the sale of the new product identical. They
are computed using the formula NCFt = [q(p) q(c+s)
D](1T) + D; where NCFt is the net cash flow in period
t. Unless a company is a tax-exempt organization, only
the after-tax amount (column E) should be used when
determining the desirability of an investment proposal.
Depreciation is not a cash flow. Because it affects the
taxes that must be paid, however, it has an indirect ef-
fect on the companys cash flows. The depreciation de-
duction shields the revenues from taxation and thereby
reduces the amount of taxes that the company must
pay. The reduction in tax payments made possible by
the depreciation tax shield is equal to D T.

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 In the Excel model, the after-tax net cash flows are
computed in three steps:
(1) The formula in cell C21 is =$C$6*$C$5-
$C$6*($C$7+$C$8)-$C$9.
(2) Cell D21 contains =1-$C$10, which is the tax
effect.
(3) Cell E21 finishes the calculation by multiplying
the annual cash flows by the tax effect and then
adding depreciation. The formula is
=(C21*D21)+$C$9.
The formulas used in C21:E21 are copied in rows
22-25. The NPV amount is computed in cell E26 using
=NPV(C11,E21:E25)+E20. Net cash flows are dis-
counted at the 10% required rate of return (C11) except
for the initial investment (E20), which is incurred now,
at t=0.
Replications of Simulation
The calculations to this point show only one possible
scenario for the five-year horizon. The $30,132 NPV in
cell E26 indicates that this independent project is
acceptablethe NPV represents a $30,000 gain (the re-
turn from the project is greater than the cost of capital,
that is the return available by investing the capital else-
where). The project is expected to add value to the
firm, and it should improve shareholders wealth, but
this might be a result of a lucky set of random numbers.
The next step is to check this by replicating the basic
simulation 100 times.
To do this, a data table is created in the range
A30:B131. Column A (A32:A131) labels each iteration,
1 through 100. To begin with the existing NPV calcula-
tion, the formula =E26 is entered into cell B31. Next,
highlight cells A31:B131. From the Data tab in the
Excel ribbon, click on the What-If Analysis dropdown
menu and select Data Table. This will bring up the
Data Table dialog box. Leave the Row Input Cell field
blank. For the Column Input Cell, select any blank cell
in the worksheet (such as C32). Click OK. This opera-
tion tricks Excel into repeating the NPV model calcula-
tions 100 times, each time using new random numbers.
Below the data table, formulas have been added to
show the mean, standard deviation, and the minimum
and maximum values of the 100 iterations (cells
A132:B135). These simulation results provide an esti-
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mate of an expected NPV of the project, as well as its
risk. With this information, it is possible to compute the
probability of achieving an NPV that is greater or less
than any particular value. The calculation is z = (x
Expected NPV)/Standard Deviation, where z is the
number of standard deviations and x is the particular
value we want to check.
For example, if we wanted to compute the probability
of achieving an NPV less than or equal to $0 using the
results in Figure 1, the calculation would be z = ($0
$24,329.62)/$10,808.35. The result is -2.25 standard de-
viations. By referring to a normal distribution table, we
can determine that the probability of a value less than -
2.25 standard deviations from the mean is 1.22%. Thus,
there is a 1.22% chance that the actual NPV will be
negative for this project.
Frequency Table and Histogram
A histogram, a graphical representation of the data dis-
tribution, can help us visualize the results from the
model and facilitate further analysis. A histogram is a
summary graph showing a count of the data points
falling in various ranges. Consequently, it is a rough ap-
proximation of the frequency distribution of the data.
Users of the model may then examine the histogram for
the general shape of the frequency distribution and its
symmetry. This may give them a better understanding
of the data and help them form expectations regarding
the probability of various outcomes. For instance, in our
example, the users may gain a better understanding of
how probable it is that the project would yield a nega-
tive NPV and, therefore, should not be accepted.
Although a histogram option is available in the
Analysis Tools (Data Analysis) in Excel that provides a
one-step method for generating a histogram, that option
does not retain a link to the data that was used to gen-
erate it. That is, the histogram will remain static and
will not change anytime the spreadsheet recalculates.
The following method does not have this drawback.
Create a frequency table of the data. This will pro-
vide data ranges for our histogram and retain a link to
the data. In Excel, this can be done using the FRE-
QUENCY formula, which calculates how often certain
values occur within a specified range and then returns a
vertical array of numbers. The syntax for the formula is
15 SUMMER 2014, VOL. 15, NO. 4
 Figure 2: Histogram of NPV After 100 Replications
Histogram of NPV
40
35
30
25
Frequency
20
15
10
0
0 10,000 20,000
=FREQUENCY(data_array,bins_array), where data_
array is the data set that contains the values for which
we want to count frequencies and bins_array is an array
containing the intervals we want to use to group the
values.
Because FREQUENCY returns an array, it must be
entered as an array formula. That requires selecting a
range of adjacent cells into which we want the returned
distribution to appear. Furthermore, the number of ele-
ments in the returned array will be one greater than the
number of elements in bins_array. The extra element in
the returned array returns the count of any values above
the highest interval.4
The frequency table appears in cells E30:G39 in
Figure 1. For this example, it shows how many NPV
observations are negative, how many are between $0
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Frequency
30,000 40,000 50,000 >50,000
NPV
and $10,000, how many are between $10,000 and
$20,000, and so on up to values greater than $50,000.
Cells E32:E37 contain the upper limit for each interval,
so they represent the bins_array. Note that cell E38 lists
>$50,000. This will be the label for the extra element in
the returned array.
Next we need to select the range G32:G38. Type in
=FREQUENCY(B32:B131,E32:E37) and then press
CTRL+SHIFT+ENTER, which enters it as an array
formula. If the formula is not entered as an array for-
mula, there will be only one result in cell G32. If
entered correctly, results will appear in each of the cells
selected.
With this frequency table formed, it is now easy to
create a histogram. Select the frequency table cells
(E32:G38) and create a column chart (see Figure 2).
16 SUMMER 2014, VOL. 15, NO. 4
The categories from column E of the frequency table in
Figure 1 serve as the labels for the horizontal axis in
Figure 2. Notice that this method of generating a his-
togram retains the link to the data. Any changes in the
data will also change the chart. To freeze the results, se-
lect and copy the range of cells, then use Paste Values
to replace the formulas with the actual numbers.
Use in the Classroom
This model was used in several graduate managerial ac-
counting classes. It was usually discussed at the end of
a lecture on capital investment decisions. After a short
introduction that described the model and its purpose,
the model was built in real-time, and simulations were
run. Students also watched the construction of the fre-
quency table and the histogram. They were usually
very interested in the topic and fascinated by the ever-
changing simulation output. The spreadsheet was later
posted online so students could further explore the in-
tricacies of the model on their own.
To reinforce students learning and their interest in
simulation, a homework project was assigned that re-
quired students to develop a different model. Students
should be made aware that when they try to build the
model using their spreadsheets, each result will un-
doubtedly be different. No two answers will ever be
exactly the same. This fact should stimulate critical
thinking and creativity.
Further Uses of the Model
The simple capital budgeting example presented in
Figure 1 can be extended in a variety of ways. For ex-
ample, more of the input variables could be made ran-
dom, or the probability distribution for individual vari-
ables used in the simulation may assume a shape other
than normal distribution.5 In addition, the NPV model
can be iterated hundreds or even thousands of times,
and simulation may enhance capital budgeting analysis
based on other techniques and decision rules.
The main objective of using this model is to demon-
strate to students that a project contains risk whenever
more than one return is possible, and they need to un-
derstand that risk is deeply inherent to capital invest-
ment decisions. Enhancing capital budgeting analysis
with risk consideration should add value to the tradi-
M A N A G E M E N T A C C O U N T I N G Q U A R T E R LY
tional managerial accounting curriculum.
Sylwia Gornik-Tomaszewski, DBA, CMA, CFM, is an as-
sociate professor in the Department of Accounting and
Taxation of The Peter J. Tobin College of Business at St.
Johns University in Queens, N.Y. You can contact Sylwia at
(718) 990-2499 or gornikts@stjohns.edu.
Additional References
Enterprise Risk Management Initiative Staff, Impact
of Risk Management Failures on the Financial
Crisis, http://erm.ncsu.edu/library/article/financial-
crisis-failures#.Us9gbNJDvNk, January 3, 2011.
Michelle M. Harner, Ignoring the Writing on the Wall:
The Role of Enterprise Risk Management in the
Economic Crisis, Journal of Business and Technology
Law, October 15, 2009, p. 45.
Jennifer Saranow Schultz, An Education in Risk
Management Can Offer a Leg Up, The New York
Times, August 20, 2009, p. F2.
Endnotes
1 For example: Charles T. Horngren, Srikant M. Datar, and
Madhav T. Rajan, Cost Accounting, 15th edition, Prentice Hall,
2014; Eric Noreen, Peter C. Brewer, and Ray H Garrison,
Managerial Accounting for Managers, third edition, McGraw-Hill,
2014; Carl S. Warren, James M. Reeve, and Jonathan Duchac,
Managerial Accounting, 12th edition, Cengage Learning, 2014;
and Susan V. Crosson and Belverd E. Needles, Managerial
Accounting, 10th edition, Cengage Learning, 2014.
2 R. Charles Moyer, James R. McGuigan, Ramesh P. Rao, and
William J. Kretlow, Contemporary Financial Management, 12th
edition, Cengage Learning, 2012.
3 Wayne L. Winston and S. Christian Albright, Practical
Management Science: Spreadsheet Modeling and Applications, fourth
edition, Cengage Learning, 2011.
4 Ibid.
5 For example, users may use the RAND function to generate
random numbers from such distributions as: (1) uniform
distribution between a and b (the Excel formula is =a + (b-
a)*RAND(), where the known values are substituted for a and
b); and (2) exponential distribution with mean m (the Excel
function is =-m*LN(Rand()), where the known value is
substituted for m).
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