Creating a simple Monte Carlo simulation model

Monte Carlo simulation is a model that calculates probabilities of different results in a process where there is much inherent uncertainty. The model makes use of randomly generated numbers to obtain thousands of possible results from which a most likely outcome can be deduced. We will look at growth in free cash flow, FCFF, as well as the cost of capital and WACC, which are both integral parts of our DCF model.

FCFF Growth rates can be calculated using the following formula:

Here are the steps to create a simple Monte Carlo simulation model:

1. Calculate the FCFF growth rates for the historical years Y02 to Y05.

Figure 11.45 – FCFF growth rates 02 to 05

Usually, a Monte Carlo simulation uses thousands of repetitions. However, for illustration purposes, we will limit the number to 100.

2. Take the average of FCFF historical growth to arrive at the (historical)...