Sequential Capital Investment Decision Making Under Extreme Cash Fl Ow Situations: Evidence Using Monte Carlo Simulation

Abstract

Abstract. Uncertainty influences a decision maker's choices when making sequential capital investment decisions. With the possibility of extremely negative cash inflows, firms may need to curtail operations significantly. Traditional Net Present Value analysis does not allow for efficient management of these problems. In addition, firm managers may behave irrationally by accepting negative Net Present Value projects in the short term. This paper presents a Monte Carlo simulation based model to provide policy insights on how to incorporate extreme cash flows and manager irrationality scenarios into the capital budgeting process. This paper presents evidence that firms with irrational managers and experiencing extremely negative cash flows may, under certain conditions, reap long term rewards associated with the acceptance of negative Net Present Value projects in the short term. These benefits are largest if cost ratios (discount rates) are small, or investment horizons are high. We argue that acceptance of short term negative Net Present Value projects implies the purchase of a long term real option which can generate positive long term cash flows under certain conditions.

Innovative Projects Scheduling with Scenario-Based Decision Project Graphs

“…The criticality of particular activities and paths as well as the probability distribution of the project duration can be also estimated on the basis of Monte Carlo simulation which ensures a highest probability of completion and is used in extremely many domains, e.g. (Suhobokov 2007;Zhang et al 2015). Monte Carlo simulation generates random values for inputs that are processed through a mathematical model in order to generate multiple scenarios.…”