Monte Carlo Simulation Cash Budgeting Models Outline

Simulation applied to Cash Flow applications

Simulation has been applied to many financial applications. This lesson covers applying Monte Carlo simulation to cash budgeting. Example: Cash Budgeting at Butson Stores
(Example, Powell & Baker, chapter 9, pp. 285-288.)

Butson Stores faces a problem maintaining sufficient cash balances for operations over the first six months of the year. Each month, they must pay certain fixed costs and taxes, as well as materials costs that run about 80 percent of the current months sales. Monthly cash receipts consist of revenues from the previous months sales, as well as 0.5 percent interest on short-term cash balances. The company enters the six-month period with a cash balance of $250,000 and wishes to maintain at least that balance each month in order to cover cash needs. December sales of $1.54 million have just been recorded. If Butson finishes a month with less than $250,000 in cash, the company can take out a one-month loan at 1 percent interest. The principal and interest are repaid in the following month. Butsons marketing department has made estimates for the mean and standard deviation of sales in each of the next six months. Given the uncertainty in sales, Butson would like to know how large their maximum monthly loan is likely to be, and how likely they are to exceed their current credit limit of $750,000. Finally, the company would like to know how much they will have to pay in interest costs for loans. Our spreadsheet model is shown below:

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Monte Carlo Simulation Cash Budgeting Models Outline

Named ranges:
COGS InitCash Interest_return_on_cash IntRateCash IntRateLoan Loans MinCashBal ='9.24'!$C$9 ='9.24'!$C$13 ='9.24'!$C$12 ='9.24'!$C$12 ='9.24'!$C$11 ='9.24'!$E$29:$J$29 ='9.24'!$C$14

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Monte Carlo Simulation Cash Budgeting Models Outline Model logic: Look at the month of February, cells F18 to F30. Cash inflows in February come from three sources: the cash balance available from the previous month, interest earned on that balance, and sales receipts (previous months sales). The cash available at the end of each month must cover the cash outflows: fixed costs and taxes (cell F24: =E8), cost of sales (80% of the current months sales), and repayment of the previous months loan (loan principal and interest on previous months loan if any). Cash balance before loan is found by subtracting the uses of cash (costs) from the sources of cash (cash and receipts). A loan is necessary if the cash balance before loan is less than $250,000, and the loan amount would be the amount necessary to obtain the required minimum balance. Final cash balance is cash balance before loan plus the loan amount. The uncertainty in this model is the sales in each month and this is determined by a random sample from a normal distribution with mean and standard deviation as shown for each month in rows 6 and 7.

Forecast cells are set up for maximum loan and loan interest.

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Monte Carlo Simulation Cash Budgeting Models Outline Results and Interpretation:

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Monte Carlo Simulation Cash Budgeting Models Outline

Example: Everglade

(Example, Hillier & Hillier, chapter 16.)

Assume the Everglade problem (described below) was solved for the optimal solution to the two types of loans available to meet cash flow problems with a solution as also shown below.
The Everglade Golden Years Company operates upscale retirement communities in certain parts of southern Florida. The company was founded in 1946, and enjoyed many successful years. Unfortunately, the past few years have been difficult ones. The demand for retirement community housing has been light, and Everglade has been unable to maintain full occupancy. However, the market has picked up recently and the future is looking brighter. Everglade has recently broken ground for the construction of a new retirement community and has more new construction planned over the next 10 years. Julie Lee is the CFO at Everglade, and has been trying to come to grips with the imminent cash flow problem. Her projection of cash flows for the next 10 years is shown in the table below. With less money currently coming in than would be provided by full occupancy, and with all the construction costs for the new retirement community, Everglade will have negative cash flow for the next few years. With only $1 million in cash reserves, it appears that Everglade will need to take out some loans in order to meet financial obligations. Also, to protect against uncertainty, company policy dictates maintaining a balance of at least $500,000 in cash reserves at all times.

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Monte Carlo Simulation Cash Budgeting Models Outline

The companys bank has offered two types of loans to Everglade. The first is a ten year loan with interest only payments made annually and then the entire principal repaid in a single balloon payment after ten years. The interest rate on the ten year loan is a favorable 7 percent per year. The second option is a series of one year loans. These loans can be taken out each year as needed, but each must be repaid (with interest) the following year. The interest rate for these short term loans is projected to be 10 percent per year. Year 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 Projected Net Cash Flow (millions of dollars) -8 -2 -4 3 6 3 -4 7 -2 10

The spreadsheet might be organized as follows:

Decision Variables: Long Term Loan and Short Term Loans Objective Function: Maximize Ending Cash Balance Constraints: Ending Balance >= Minimum Balance

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Monte Carlo Simulation Cash Budgeting Models Outline Key relationships:

LT Interest = - Long Term Interest Rate * Long Term Loan ST Interest = - Short Term Interest Rate * Prior Period Short Term Loan LT Payback = - Long Term Loan (Dec Var) ST Payback = - Prior Period Short Term Loan (Dec Var) Ending balance = Starting balance + Cash flow + Loans Interest payments Loan paybacks

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Monte Carlo Simulation Cash Budgeting Models Outline Using the most likely cash flow in a deterministic model yields an ending balance of $2.92. Our optimal solution was determined assuming no deviation from the projected cash flows. Maintaining this solution for the long term loan we want to incorporate uncertainty for the cash flows and determine the likelihood of achieving a positive cash balance at the end of the ten years. We will model the uncertainty of the cash flows for each year using a triangular distribution with parameters as shown below:

We will incorporate the uncertainty into our model, identify our forecast cell and run the simulation to answer the management question about our risk.

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Monte Carlo Simulation Cash Budgeting Models Outline

The result of our Monte Carlo analysis reveals there is about an 87% chance the ending balance will be positive:

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Monte Carlo Simulation Cash Budgeting Models Outline

Correlations and Implications

(based on Chapter 5, Charnes)

Suppose we have two assets with return characteristics as shown below:

Further suppose the correlation between those can be set in D5. We want to explore the impact of correlation on the portfolio return assuming an equal mix of these two assets. We will define correlation as a decision variable and then use a Decision Table to explore this relationship:

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Monte Carlo Simulation Cash Budgeting Models Outline

Chart: Trend

Chart: Overlay (-0.75, 0.0, 0.75)

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Monte Carlo Simulation Cash Budgeting Models Outline Logic for Enston Company (upcoming lab problem)
The Entson Company believes that its monthly sales during the period from November to July of the next year are normally distributed with means and standard deviations given in the accompanying table. Each month Entson incurs fixed costs of $250,000. In March taxes of $150,000 and in June taxes of $50,000 must be paid. Dividends of $50,000 must also be paid in June. Entson estimates that its receipts in a given month are a weighted sum of sales from the current month, the previous month, and two months ago with weights of 0.2, 0.6 and 0.2. In symbols, if Rt and St represent receipts and sales in month t, then:

Rt = 0.2 * S t 2 + 0.6 * S t 1 + 0.2 * S t

The materials and labor needed to produce a months sales must be purchased one month in advance, and the cost of these averages to 80% of the products sales. For example, if sales in February are $1,500,000, then the February materials and labor costs are $1,200,000, but these must be paid in January. At the beginning of January Entson has $250,000 in cash. The company would like to ensure that each months ending cash balance never dips below $250,000. This means Entson might have to take out short-term (one month) loans. For example, if the ending cash balance at the end of March is $200,000, Entson will take out a loan for $50,000, which it will then pay back (with interest) one month later. The interest rate on a short-term loan is 1% per month. At the beginning of each month, Entson earns interest of 0.5% on its cash balance. The company would like to use simulation to estimate the maximum loan it will need to take out to meet its desired minimum cash balance. It would also like to see how sensitive the results are to the sales data. In particular, considering this data as a base case, it would like to run a simulation in which the means are 20% below the values in the table and another simulation in which the means are 20% above those in the table.

Chronological sequence: Entson observes its beginning cash balance. Entson receives interest on its beginning cash balance. Receipts arrive and expenses are paid (including payback of the previous months loan, if any, with interest). If necessary, Entson takes out a short-term loan. The final cash balance is observed, which becomes next months beginning cash balance.

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Monte Carlo Simulation Cash Budgeting Models Outline Given information incorporated into spreadsheet model:

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