Definition: The Simulation Analysis is a method, wherein the infinite calculations are made to obtain the possible outcomes and probabilities for any choice of action.
The concept of simulation analysis can be further comprehended through the following steps:
- The first step is to model the project. A model shows how the net present value is related to the parameters and the exogenous variables. The parameters are the variables specified by the decision maker and are held constant throughout the simulation, whereas the exogenous variables are randomly determined and are beyond the control of the decision maker.
- The next step is to specify the values of the parameters and assign probabilities to the random variables that arise from the external factors.
- Randomly, select any value from the probability distribution of each of the exogenous variables.
- Compute the NPV for both the randomly generated values of exogenous variables and the parameter values, as specified by the decision maker.
- Repeat the step 3 and 4 again and again, to get a large number of simulated values of NPV.
This whole process of simulation analysis compels the decision maker to consider all the interdependencies and uncertainties characterizing the project. Thus, the viability of the project is determined on the basis of number of outcomes and the probabilities realized through a series of actions performed during the simulation analysis.