Unit Title: Advanced Financial Management

Unit Code: HBF 2302

TASK: Utility and Simulation Analysis

ELIUD KIMARU HDB223-0501/2018

SYLAS KAMAMA HDB223-0504/2018
EDWIN NDEGWA HDB223-0810/2018
BENARD MUTISYA HDB223-0797/2018
SARAH WANJIKU HDB223-0457/2018
Utility Theory
In contrast to the approaches for handling risk, utility theory aims at incorporation of decision maker’s
risk preference explicitly into the decision procedure.
A rational decision maker would maximize his utility, thus would accept the investment project which
yields maximum utility to him.
The utility theory approach can be applied to investment decisions, provided the decision maker’s utility
functions could be defined.
The advantages of the utility analysis include:

a) The risk preferences of the decision makers are incorporated directly into the capital budgeting
analysis. As such the decision maker are capable of deriving the into the utility from the
outcomes provided from the capital budgeting analysis.
b) It facilitates the process of delegating the authority for decisions-Through utility theory the
respective authorities can arrive at the decisions that suits their expectations and satisfaction.
c) The decision maker, the subordinate can be asked to take the risk consistent with the risk
preferences of the superior if its is possible to specify the utility function of subordinate the
superior.

The drawbacks include the following

a) In reality difficulties are encountered while developing and specifying the utility function. This is
due to the idea that the utility theory in capital budgeting is not common in capital budgeting.
b) Even though the dominant shareholder’s utility function is used as a guide, the derived utility
function at a point of time is valid only for that one point of time.
c) It is quite difficult to specify the utility function if the decision is taken by the group of persons.
Individuals differs in the risk preferences. As results it is difficult to derive a consistent utility
function for the group.

Example
Let us assume that the owner of a firm is considering an investment project, which has a 60% of
probability of yielding NPV of Rs 10 lakh and 40% probability of a loss of NPV of Rs 10 lakh.
The projects expected NPV is;
NPV = 10 × 0.6 + (- 10) × 0.4 = Rs 2 lakh.

Should the project be accepted?

Without considering the owners utility function, the answer is affirmative since the project has a positive
expected NPV of Rs lakh. However, the owner may be risk averse, and he may consider the gain in utility
arising from the positive outcome less than the loss in utility as a result of the negative outcome.

The incremental cost-effective ratio (ICER), also known as the cost per QALY, is used in utility analysis.
This is derived by dividing the difference between the estimated costs of two treatments by the predicted
QALYs provided by the two strategies.

Illustration:
For example, a digital product for managing heart failure generates 4 QALYs compared to an alternative
option. If that digital product costs £4,000 more than the alternative, then the ICER would be £4,000
divided by 4, that is £1,000 per QALY.

This measure is useful to inform resource allocation decisions at national level. It allows a quick
assessment of whether a specific product is cost-effective by identifying whether the ICER is below the
maximum a decision-maker is willing to pay for a QALY.

Example 2;
For example, the cost per QALY threshold by NICE for England and Wales is between £20,000 and
£30,000. The example digital product for managing heart failure would be judged highly cost-effective
because its ICER (£1,000 per QALY) is well below this threshold.
SIMULATION ANALSIS

Simulation analysis also known as Monte Carlo analysis, this is the analysis that consider the interaction
among the variables and the probabilities in change in variables. It does not give the projects NPV as a
single number; rather it computes the probabilities of distribution of NPV. Hence the simulation analysis
act as the extension of scenario analysis.

Illustration

Units of sales probability

20000 0.25

30000 0.40

50000 0.35

Price per unit probability

60 0.20

80 0.55

100 0.25

Variable cost probability

20 0.45

30 0.25

40 0.30

The fixed cost is 50000, the initial investment is 1.1 million and cost of capital is 10%. You are also given
the following random numbers for five runs.
Run Number Price Per Unit Variable Cost Units of Sales

1 25 54 67

2 89 02 12

3 60 88 55

4 90 60 15

5 40 99 20

Required;

Determine simulated NPV.

Solution

Random Number Ranges

Price Per Unit Prob Cum. Prob RN Range

60 0.20 0.20 00 - 19

80 0.55 0.75 20 - 74

100 0.25 1.00 75 – 99

Variable Cost Prob Cum. Prob RN Range

20 0.45 0.45 00 – 44

30 0.25 0.70 45 – 69

40 0.30 1.00 70 – 99

Units of Sales Prob Cum. Prob RN Range

20000 0.25 0.25 00 – 24

30000 0.40 0.65 25 – 64

50000 0.35 1.00 65 – 99

Simulation Worksheet

Run No. RN Price Per Unit RN Variable Cost RN Units of Sales Profit

1 25 80 54 30 67 50000 2450000

2 89 100 02 20 12 20000 1550000

3 60 80 88 40 55 30000 1150000

4 90 100 60 30 15 20000 1350000

5 40 80 99 40 20 20000 750000

Simulated NPV = [2450000/1.1 + 1550000/1.1^2 + 1150000/1.1^3 + 1350000/1.1^4 + 750000/1.1^5]

-1100000

= 4660035.60

The NPV is positive hence the project is acceptable.

Steps in formulation of simulation analysis

 Identification of variables that can influence the cash outflow and cash inflows, for example when
affirm introduces a new product in the market, these products are initial investment, market size,
market growth, market share, price, variable cost, fixed costs, product life circle and terminal
values.
 Specify the formula that relate the variables. For example, variable depend on sales volume and
price; sales volume is given by market size, market share and market growth similarly operating
depend on the production, sales and variable and fixed costs.
 Indicate the probability distribution for each variable. Some variable will have more uncertainty
than others. For example, its quite difficult to predict price or market price with confidences.
 Developed a computer programmed that Randomly select one values from the probabilities
distribution of each variable and uses these values to calculate the projects NPV. The computer
 can generate a large number of such scenarios, calculate the NPV and store them. The stored
values are printed as the probability distribution of the projects NPV along with the expected
NPV and its standard deviation. The risk-free rate should be used as the discount rate to compute
the project NPVs. Since formulation is performed to account for the risk of the project cash
flows, the discount rate should reflect the time value of money.

Advantages of modelling and simulation

 Can be safer and cheaper than the real world.

 Able to test a product or system works before building it.

 Can use it to find unexpected problems.

 Able to explore ‘what if…’ questions.

 Can speed things up or slow them down to see changes over long or short periods of time.

Demerits of simulation analysis

1. The model is quite complex to use because the variable is interrelated with each other, and each
variable depend on its values in the previous period as well. Identifying all possible relationships
and identifying probability distribution is a difficulty tusk it’s also time consume time and
expensive to undertake.
2. The model helps in generating probability distribution of the project NPVs. But it does not
indicate whether or not the project should be accepted.
3. It considers the risk of any project is isolation of other projects because if we consider the
portfolio of projects, the unsystematic risk can be diversified. A risk project can be diversified. A
risky project may have a negative correlation with the firms’ other projects, and therefore
accepting the project may reduce the overall risk of the projects.