Chapter 

5 
 
Using Simulation to Develop
Business Strategy 
 

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©2003, Entrepreneurial Finance, Smith and Kiholm Smith 

Chapter 5 

Learning  Objectives   

 Learn 
the advantages of using simulation to 
evaluate scenarios described by decisi
on trees.
 Learn the steps involved to develop a
simulation model for a new venture.
  Make better strategic decisions using
and evaluating statistical information
produced by a simulation model.
 Apply simulation techniques to value
real options facing new ventures.
©2003, Entrepreneurial Finance, Smith and Kiholm Smith 

Chapter 5 

Applications  of Simulation   

 Strategy  formulation
 Deal structuring
 Risk allocation
 Contingent claims analysis
 Cash needs assessment
 Staging of investments
 Valuation
©2003, Entrepreneurial Finance, Smith and Kiholm Smith 

Chapter 5 

Essentials 
of Simulation: A Simple Exa
 mple - Estimating 
Space Needs  

 A model 
- The amount of warehouse space need
ed  for storage of boxes:
o Volume per box = Height x Width x

Depth
 Specification of assumptions and
description of uncertainties
o 5000 boxes per day

o Sizes: 1 x 1 x 1, 2 x 1.5 x 1.5, and 3

x2x2
o Sizes are equally likely.

 Run the simulation (Excel file).

©2003, Entrepreneurial Finance, Smith and Kiholm Smith 

Chapter 5 

Using 
Simulation to Study Options  

 A model
 Calls and Puts on an underlying
o

share of stock
o Terminal value of Call = Stock price -

Exercise price
 Specification of assumptions and
description of uncertainties
o Stock sells today for $118

o Exercise price for call or put is $125

o Expected monthly appreciation of

stock = 1%,
    +  or - 4% per month
Risk-free rate is 0.3% per month
o

 Run the simulation (Excel file).

©2003, Entrepreneurial Finance, Smith and Kiholm Smith 

Chapter 5 

Evaluating 
Strategic Alternatives by Sim
ulation  
  Step 
1: Identify the strategic alternatives.
 Step 2: Determine evaluation criteria.
 Step 3: Construct a model of the
strategic decisions.
 Step 4: Specify assumptions and
describe uncertainties.
 Step 5: Run the simulation and evaluate
the results.
©2003, Entrepreneurial Finance, Smith and Kiholm Smith 

Chapter 5 

Identification 
of Strategic Alternatives: The 
Restaurant Example 
Continued  

 Build  a large restaurant
o Without option to convert (abandon

restaurant business)
o With option to convert

 Build a small restaurant

 oWithout option to expand
o With option to expand

o Without option to convert

o With option to convert

 Do not invest
o Without future consideration

o With option to delay

©2003, Entrepreneurial Finance, Smith and Kiholm Smith 

Chapter 5 

Evaluation  Criteria  

 Maximum  NPV for the entrepreneur
 Other?
©2003, Entrepreneurial Finance, Smith and Kiholm Smith 

Chapter 5 

Model 
of the Large Restaurant  

 PV  Cash Flow = PV(Revenue - Cash

Expenses - Depreciation) x (1 - tax rate)
+ PV Depreciation
  Simplify - Private corporation with no
effective tax liability. PV Cash Flow =
PV Revenues - PV Cash Expenses
 PV Revenues = PV Unit Price x Unit
Sales (over life of restaurant)
 Unit Sales = Lesser of Demand
Quantity or Capacity
 Demand Quantity = Market Size x
Market Share
 Capacity = An assumed maximum
value
 PV Cash Expenses = PV Unit Cost x
Unit Sales + PV Fixed Costs
 Result is PV of restaurant
©2003, Entrepreneurial Finance, Smith and Kiholm Smith 

Chapter 5 

Model 
of Restaurant, Continued: Re
turn to the  Entrepreneur  
  PV Entrepreneur 
Interest = PV Cash Flows - PV Outside 
Investor Interest
 PV Outside Investor Interest = (Total
Investment - Entrepreneur Investment) x
Percent Equity Per Dollar Invested x PV
Cash Flows
 NPV Entrepreneur Interest = PV
Entrepreneur Interest -  Entrepreneur
Investment
 Model the small restaurant in a similar
way
 Build in various options by modifying the
model.`
©2003, Entrepreneurial Finance, Smith and Kiholm Smith 

Chapter 5 

Assumptions 
and Statistical Processes of t
he Large  Restaurant Model
©2003, Entrepreneurial Finance, Smith and Kiholm Smith 

Chapter 5 
 Simulation 
Statistics - 300 Trials  

Figure  5-3
©2003, Entrepreneurial Finance, Smith and Kiholm Smith 

Chapter 5 

Market 
Size Simulation Results  

Figure  5-4(a) 
Market  Size (in thousands of meals) 
Note: The figure represents a simulation of market size with 300 iterations.

©2003, Entrepreneurial Finance, Smith and Kiholm Smith 

Chapter 5 

Market 
Size Simulation Results  

Figure  5-4(b) 
Market  Size (in thousands of meals) 
Note: This figure shows the effect of increasing the number of iterations in the
simulation to 5,000. The shape of the sampling distribution conforms closely
to the underlying triangular distribution assumed in the simulation

©2003, Entrepreneurial Finance, Smith and Kiholm Smith 

Chapter 5 

Histogram  of Unit Sales 
Simulation Results  

Figure  5-5 
Unit  Sales (in thousands of meals) 
Note: This figure shows the results of 300 iterations of the large restaurant
unit sales simulation, with capacity constrained at 500,000 meals

©2003, Entrepreneurial Finance, Smith and Kiholm Smith 

Chapter 5 

Convergence 
NPV to Entrepreneur  

Figure  5-6 
Note: This figure shows the convergence of the large restaurant
entrepreneur’s estimated NPV as the number of iterations is increased from
one (the left-most point) to 300 (the right-most point).

©2003, Entrepreneurial Finance, Smith and Kiholm Smith 

Chapter 5 
 Small 
Restaurant NPV to Entrepre
neur  

Figure  5-7 
Note: The figure shows the sample distribution of the entrepreneur's NPV
from 600 iterations of the simulation model for investing in the small
restaurant. The effect of the abandonment option is reflected in the figure by
the limitation of negative NPVs.

©2003, Entrepreneurial Finance, Smith and Kiholm Smith 

Chapter 5 

Option 
Structure of Small Restauran
t NPV to Entrepreneur  

Figure  5-8
©2003, Entrepreneurial Finance, Smith and Kiholm Smith 

Chapter 5 
 Option 
Structure of Large Restauran
t NPV to Entrepreneur  

Figure  5-9
©2003, Entrepreneurial Finance, Smith and Kiholm Smith 

Chapter 5 

Large 
Restaurant Conditional on D
eciding to Delay  

Figure  5-10
©2003, Entrepreneurial Finance, Smith and Kiholm Smith 

Chapter 5 

Small  Restaurant  
Option to Expand  

Figure  5-11
©2003, Entrepreneurial Finance, Smith and Kiholm Smith 
Chapter 5 

End  of Chapter  
Questions 
Note: Please Be Familiar With
Venture.SIMTM Before 
Attempting These Problems.
©2003, Entrepreneurial Finance, Smith and Kiholm Smith 

Chapter 5 

Question  5-1 
You have spent 
last 6 months developing a new product 
for 
treatment of 
arthritis and believe that a breakthrough 
could occur 
any time in 
the next 8 months and that there 
is a 10% chance of 
success in 
any given month. You have decided to 
abandon the 
project if 
you do not succeed within that period.
 In the event of success, clinical testing
required for FDA approval will take 6 to
10 months. Based on experience, if
developmental efforts are successful,
there is a 80% chance that approval will
be granted. Approval or disapproval in
any month is equally likely.
 Your venture consumes cash at an
average rate of $30,000 per month.
 You estimate that in any given month,
there is a 30% chance that the cost will
be $20,000 and 20% chance that it will
be $45,000.
 The cost of financing will be lower once
approval is obtained. The problem is
that you need additional financing right
now.
 

©2003, Entrepreneurial Finance, Smith and Kiholm Smith 

Chapter 5

©2003, Entrepreneurial Finance, Smith and Kiholm Smith 

Chapter 5 

Question  5-1 (Cont’d) 
o Suppose 
you want to provide enough financin
g for 
the worst case outcome. How much 
money  should you raise?
o Using a simulation model,determine
how much you should raise now so
that the probability of running out of
money before the FDA acts is 25%.
o Suppose the cost of financing would
also be lower after development was
completed. How could you use
simulation to determine the best way
to stage the financing of the venture?
What factors would affect your
 choice of when and how much
capital to raise?
 

©2003, Entrepreneurial Finance, Smith and Kiholm Smith 

Chapter 5

©2003, Entrepreneurial Finance, Smith and Kiholm Smith 

Chapter 5 

Question  5-2  
An entrepreneur 
who would like to open a restaurant 
has approached you. By coincidence, it 
is the same entrepreneur whose decision 
you have been studying in this chapter.  
He is offering 1% of equity for every 
$10,000 and will contribute $400,000.  
Suppose you agree with entrepreneur’s ass
umption  as outlined in Fig 5-2 for the large 
restaurant, and elsewhere in the Chapter 
for the small restaurant, including the 
PV assumptions. Use simulation to examin
e 
the opportunity from your perspective instea
d  of the entrepreneur’s.
o What is the NPV of your investment
in the large restaurant if there no
options and investment is
immediate?
o What is the NPV of your investment
in the small restaurant if there are no
options and investment is
immediate?
o How do abandonment options with
exercise values of $600,000 and
$300,000 for the large and small
restaurant respectively, affect the
NPVs of your prospective
investments?
 
 

©2003, Entrepreneurial Finance, Smith and Kiholm Smith 

Chapter 5

©2003, Entrepreneurial Finance, Smith and Kiholm Smith 

Chapter 5 
 Question  5-2 (Cont’d) 
o Suppose, 
to acquire an abandonment option fo
r either 
restaurant, the expected cost is $20,
000 
higher (which you would pay in exch
ange 
for an additional 2% of the equity). 
Would you want the entrepreneur to 
acquire  the option?
o The entrepreneur proposes to build a
small restaurant initially, and if
expected demand turns out to be
more than 300,00 meals, to expand
the capacity to the same as the large
restaurant. The cost of expanding is
$300,00 and the entrepreneur
proposes that you contribute that
amount in exchange for an additional
15% of equity. Based on the
simulation, would you accept the
 proposal? Why or why not? Is there
another alternative under which the
entrepreneur could exercise the
expansion option, that you would find
more attractive?
 

©2003, Entrepreneurial Finance, Smith and Kiholm Smith 

Chapter 5

©2003, Entrepreneurial Finance, Smith and Kiholm Smith 

Chapter 5 

Question  5-3 
The monthly  standard deviation of the S&P 500 
index is 6.8%.  The expected return 
for investing in the index is 1%  per month
o Suppose you invest $100 in the index today
 Use simulation to estimate the expected
value and standard deviation of the
investment at the end of 3 months
 What is the estimated expected value and
standard deviation at the end of 9 months?
o Suppose, instead of investing $100 in the index,
you are interested in a call option on the $100
claim on the index
  What are the expected value and standard
deviation of a 3 month call in 3 months with
an exercise price of $100?
 What are the expected value and standard
deviation of a 9 month call in 9 months with
and exercise price of $100?
 What is the expected value in 9 months of a
9 month call on an index value of $100 if the
exercise price is $90?
 
 

©2003, Entrepreneurial Finance, Smith and Kiholm Smith 

Chapter 5

©2003, Entrepreneurial Finance, Smith and Kiholm Smith 

Chapter 5 

Question  5-4  
Think about 
an aspect of your current situation (possibly 
related to 
your career,  education, or personal life). 
 What are the most important decisions
you will have to make as you go
forward?
  Try describing the alternatives in terms
of a decision tree.
 What real options are reflected in the
choices you will have to make?
 The outcomes of the branches should
be describable in terms such as dollars,
utility, and happiness. See, if you can
write a model, similar to the one in the
chapter, that describes how outcomes
relate to your possible choices.
 Now, supposing that you wanted to
simulate the results of your decisions,
how might you go about specifying the
assumptions of your model?
 If you feel ambitious, try setting up the
model in an Excel spreadsheet and use
simulation to evaluate the choices.
 

©2003, Entrepreneurial Finance, Smith and Kiholm Smith 

Chapter 5

©2003, Entrepreneurial Finance, Smith and Kiholm Smith 

Chapter 5 
 Question  5-5  
Refer to the 
restaurant example in the chapter. “If 
the investor is astute, the terms of 
deal will be different for the large 
restaurant than for the small one.” 
Why and how do you think they might 
be different? 
©2003, Entrepreneurial Finance, Smith and Kiholm Smith 

Chapter 5

©2003, Entrepreneurial Finance, Smith and Kiholm Smith 

Chapter 5 

Question  5-6  
The origin 
of the term “real options” is traceable to 
Professor Stewart Myers (“Determinants of 
Capital  Borrowing”, 5 Journal of Financial
Economics, 1977), who noted that many
corporate real assets can be viewed as call
options.
o What do you think he means?
 o Why might it be useful to think of
corporate real assets as call
options?
Provide examples 
to illustrate your answer. Try to identify, 
at least conceptually, the underlying asset, 
the exercise price, and the expiration  date. 
©2003, Entrepreneurial Finance, Smith and Kiholm Smith 

Chapter 5

©2003, Entrepreneurial Finance, Smith and Kiholm Smith 

Chapter 5 

Question  5-7  
Re-evaluate the 
storage space needed in the box example 
in Section 5.1.  However, instead of 
5000 boxes per day, you expect from 
4000 to 6000 per day.  The actual 
number will be drawn from a uniform 
distribution over this range.
o What is the maximum size of
warehouse you will need?
 o Estimate the size that would be
sufficient 95% of the days.
o How does this compare to the
estimate in the text, of the size that
would be sufficient 95% of the days?
o What do you think accounts for the
differences in size?
 

©2003, Entrepreneurial Finance, Smith and Kiholm Smith 

Chapter 5

©2003, Entrepreneurial Finance, Smith and Kiholm Smith 

Chapter 5 

Question  5-8  
The  common 
stock of Unron is selling today for 
$50 per share. The stock is expected 
to appreciate at a rate of 1% per 
month with a standard deviation of 15% 
per month.  As an Unron employee, 
you have just been awarded executive stoc
k  options to acquire 1000 shares: Exercise 
price = $50.  Cannot be sold or 
exercised for 5 years (60 months).  
Monthly risk free rate is 0.3%.
o Simulate the price of Unron stock at
the end of five years and the value of
the call option at expiration.
o What is the likelihood for the option
to be in the money at expiration?
o What are the expected stock price
and expected value of the call option
in 5 years?
o As you cannot trade the options, you
cannot use conventional option
pricing models to determine their
value. What is the present value of
the options if you discount their
expiration date value by 1% per
month?
o What is the present value if you
discount their expiration date value
by the risk free rate?
 
 
 
©2003, Entrepreneurial Finance, Smith and Kiholm Smith 

Chapter 5

©2003, Entrepreneurial Finance, Smith and Kiholm Smith 

Chapter 5 

Question  5-9 
Download the  Black-
Scholes Option value Template from the 
text Web site and use it to value 
the following options on Unron stock (See 
problem 8).
o 1 year calls with exercise price of
$50
o 1 year calls with exercise price of
$40
o 1 year puts with exercise price of
$50, $40
o Six month calls and puts with
exercise price of $50, $40
o For 1 year puts and calls with
exercise price of $50, how does the
value change if the risk free rate
increases to 0.5% per month?
 o For 1 year puts and calls with
exercise price of $50, how does the
value change if the monthly standard
deviation decreases to 10%?
Discuss the 
consistency of your findings with the 
principles of option valuation. 
©2003, Entrepreneurial Finance, Smith and Kiholm Smith 

Chapter 5

©2003, Entrepreneurial Finance, Smith and Kiholm Smith 

Chapter 5 

Question  5-10 
For the restaurant 
example in the chapter, evaluate the combi
ned 
effects of the following assumption changes 
on the values of large and small 
restaurants and the effects on the various 
options on value
o The standard deviation of meal
prices is $2.
 o The preliminary market size estimate
has a triangular distribution with
(8,2.6 and 0.5 million units).
o The preliminary estimate of market
share has a standard deviation of
2%.
How do these 
assumptions of increased risk affect optimal 
strategy?  Why do you think the effects 
are as you find them to be? 
©2003, Entrepreneurial Finance, Smith and Kiholm Smith 

Chapter 5

©2003, Entrepreneurial Finance, Smith and Kiholm Smith 

Chapter 5 

Question  5-11 
For the restaurant 
example in the chapter, evaluate the combi
ned 
effects of the following assumption changes 
on the values of large and small 
restaurants and the effects on the various 
options on value
o The expected variable cost per meal
is $4
o Expected fixed cost of the large
restaurant is $750,000
o Expected cost of the small restaurant
is $600,000
How do these 
assumptions about the variable and fixed 
cost structures affect optimal strategy?
Why do you 
think the effects are as you find 
them to be? 
©2003, Entrepreneurial Finance, Smith and Kiholm Smith 

Chapter 5