I have a question related to discount rate and monte carlo simulation in the curriculum in level II, volume III (corporate finance). When estimating the value of a company using the WACC and DCF, it is assumed that the cash flow is the expected value of the cash flow in each year. If we instead of using expected value in the DCF use monte carlo simulation to simulate a large number of possible outcomes for the cash flow in every year, every outcome is obviously not the expected value. What discount rate should then be used to calculate the enterprise value for each simulation, and how is this discount rate calculated?
WACC and DCF usually have to do with projects or scenarios where there arent that many possibilities. monte carlo is used for situations where there a many different outcomes. MBS use monte carlo
Interesting question. WACC depends on the capital structure, as well as cost of equity and debt. Nevertheless, also a Monte Carlo simulation has got an underlying distribution, i.e. usually we should be able to determine the expected cash flow at a certain time. The cost of equity will rise with the volatility of cash flow outcomes in the simulation, however if we know the variance of the underlying distribution, we are also able to calculate the required return on equity. So in this case WACC would be quite easily computable. Has anyone used this in practice?