Spreadsheet Demonstration New Car Simulation

2 New car simulation Basic problem  To simulate the profitability of a new model car over a several-year period to check its profitability in terms of net present value (NPV)  NPV is used so that company can compare this investment with other potential investments  Many costs are uncertain at the outset  To simulate the profitability of a new model car over a several-year period to check its profitability in terms of net present value (NPV)  NPV is used so that company can compare this investment with other potential investments  Many costs are uncertain at the outset

3 New car simulation Uncertainties  Yearly demand for car - assumptions are:  Demand in year 1 is normally distributed, known mean and standard deviation  Demand in typical year is normally distributed, known standard deviation, mean equal to actual demand in previous year  Builds in correlation among demands  Yearly demand for car - assumptions are:  Demand in year 1 is normally distributed, known mean and standard deviation  Demand in typical year is normally distributed, known standard deviation, mean equal to actual demand in previous year  Builds in correlation among demands

4 New car simulation Uncertainties  Fixed development cost (only in year 1)  Assumed normally distributed, known mean and standard deviation  Fixed development cost (only in year 1)  Assumed normally distributed, known mean and standard deviation

5 New car simulation Uncertainties  Variable unit production cost - assumptions are:  Variable cost in year 1 is normally distributed with known mean, standard deviation  Variable cost in a typical year is previous year’s value times an inflation factor  Inflation factor each year is normally distributed with known mean, standard deviation  Variable unit production cost - assumptions are:  Variable cost in year 1 is normally distributed with known mean, standard deviation  Variable cost in a typical year is previous year’s value times an inflation factor  Inflation factor each year is normally distributed with known mean, standard deviation

6 New car simulation Revenues  Unit price is set in year 1  Unit price in a typical year is price from previous year times the same inflation factor used for variable costs  Unit price is set in year 1  Unit price in a typical year is price from previous year times the same inflation factor used for variable costs

7 New car simulation Other assumptions  Production quantity in any year is set as:  Expected (forecast) demand plus a multiple of the standard deviation of demand  This multiple is essentially a decision variable  Leftover cars any year are sold at a 30% discount  For purposes of calculating NPV, interest rate of 10% is used  Production quantity in any year is set as:  Expected (forecast) demand plus a multiple of the standard deviation of demand  This multiple is essentially a decision variable  Leftover cars any year are sold at a 30% discount  For purposes of calculating NPV, interest rate of 10% is used

8 Developing the spreadsheet model (See Excel “Step 1” sheet)  Step 1: Enter all assumptions and inputs, including:  Parameters of various normal distributions  Multiple that determines production strategy  Percentage markdown for leftover cars  Interest rate  Step 1: Enter all assumptions and inputs, including:  Parameters of various normal distributions  Multiple that determines production strategy  Percentage markdown for leftover cars  Interest rate

9 Developing the spreadsheet model (See Excel “Steps 2-8” sheet)  Steps 2-8: Calculate the following, generating random numbers when needed:  Inflation factors  Production quantities  Demands  Variable costs  Revenues  Steps 2-8: Calculate the following, generating random numbers when needed:  Inflation factors  Production quantities  Demands  Variable costs  Revenues

10 Developing the spreadsheet model (See Excel “Steps 9-11” sheet)  Step 9: Generate the (one-time) fixed cost  Step 10: Use Excel’s NPV function to calculate the NPV of the production cost stream and the revenue stream  Step 11: Calculate the total NPV  The fixed cost is tacked on separately because it occurs right away and isn’t discounted  Step 9: Generate the (one-time) fixed cost  Step 10: Use Excel’s NPV function to calculate the NPV of the production cost stream and the revenue stream  Step 11: Calculate the total NPV  The fixed cost is tacked on separately because it occurs right away and isn’t discounted

11 Developing the spreadsheet model (See Excel “Replications” sheet)  Create a data table to replicate the simulation  Keep track of total NPV for the 10-year period  Calculate summary measures (average, standard deviation, minimum, maximum, frequency table, confidence interval for mean NPV) based on this data table  Create a data table to replicate the simulation  Keep track of total NPV for the 10-year period  Calculate summary measures (average, standard deviation, minimum, maximum, frequency table, confidence interval for mean NPV) based on this data table

12 Developing the spreadsheet model (See Excel “Histogram” sheet)  Based on the frequency table, create a histogram of the total NPVs  The three left-most bars are of particular importance to the company  They show how often a negative NPV is obtained  Based on the frequency table, create a histogram of the total NPVs  The three left-most bars are of particular importance to the company  They show how often a negative NPV is obtained