Risk analysis in investment appraisal

Abstract

*This paper was prepared for the purpose of presenting the methodology and uses of the Monte Carlo simulation technique as applied in the evaluation of investment projects to analyse and assess risk. The first part of the paper highlights the importance of risk analysis in investment appraisal. The second part presents the various stages in the application of the risk analysis process. The third part examines the interpretation of the results generated by a risk analysis application including investment decision criteria and various measures of risk based on the expected value concept. The final part draws some conclusions regarding the usefulness and limitations of risk analysis in investment appraisal.

Assessing the value of wind generation in future carbon constrained electricity industries

“…Key uncertain input parameters and their probabilities are modeled based on historical data and independent expert opinion in the literature, as described in Section 3.3. Given that decision-making in generation investment and planning inevitably requires decision-makers forming some views about future drivers such as fuel prices and various cost factors, historical data and expert opinions are often used in the absence of better approaches (Savvides, 1994). Note, however, that this tool does not force tight constraints on the way that future uncertainty is incorporated.…”

The Use of Monte Carlo Simulation Technique to Support Investment Decisions

“…The extent of maximum loss possible under conditions of limited liability is usually defined by the legal agreements entered into by the various parties involved in a project [5]. Looking at the investment in terms of the present value the equity holders cannot lose more than the present value of their equity capital, the debt holders can only lose the present value of their loan capital, the creditors the present value of the extended credit and so on.…”

“…Conversely, a project variable with high uncertainty should not be included in the probabilistic analysis unless its impact on the project result, within the expected margins of uncertainty, is significant. The reason for including only the most crucial variables in risk analysis application is twofold [5]:…”

Sustainability and Risk: Towards a Risk-Based Sustainability Rating for Real Estate Investments

“…Monte Carlo simulations have been described as a possibility for risk analysis in the context of investment appraisal for quite some time (for example Savvides, 1994). They are especially suitable in cases where non diversifiable risks strongly affect the value of an investment (for example in the case of nuclear power plants Rode et al, 2001).…”

“…In investment appraisal (not necessarily real estate), the steps for risk analysis with Monte Carlo simulations are well described (Savvides, 1994): 1. determine an appraisal model 2. determine (objective or subjective) probability distributions of future outcomes 3. separate important from unimportant variables in appraisal model, based on the sensitivity of the result with regard to the variable 4. identify and describe correlations of future outcomes In our case, the appraisal model is a discounted cash flow model, as proposed by Muldavin, 2010 andLorenz andLützkendorf, 2011. As it is used to determine the contribution of ESI sub-indicators to risk, we use a slightly reduced DCF structure, for example excluding expected average vacancy:…”