Monte Carlo simulation in investment appraisal
Monte Carlo simulation specifies probability distributions for uncertain inputs, samples combinations and recalculates an output such as NPV across many trials. The resulting distribution can inform estimates of expected value, downside risk and the proportion of simulated outcomes below zero. The results are conditional on assumptions, correlations and model structure; a large number of trials cannot repair biased inputs or omitted risks. Current AFM requires interpretation and discussion of simulation output, not the execution of a simulation in the examination.
Worked example
A model simulates uncertain demand and selling price for a project. Of 10,000 simulated NPVs under the stated assumptions, 1,800 are negative, suggesting an 18% modelled probability of negative NPV. The analyst checks the input distributions and their correlation before using that result.
Common mistake
Treating a simulated 18% as an observed certainty, or assuming more trials make unrealistic inputs accurate.
Where it appears in your exams
| Qualification | Exam | Relationship | Period |
|---|---|---|---|
| ACCA | AFM | Direct | September 2026–June 2027 |