Risk analysis in investment appraisal based on the Monte Carlo simulation technique

This work has been 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 analyze and assess risk. In the deterministic appraisal the basic decision rule for a project is simply to accept or reject the project depending on whether its net present value (NPV) is positive or negative, respectively. Similarly. when choosing among alternative (mutually exclusive) projects, the decision rule is to select the one with the highest NPV, provided that it is positive. Recognizing the fact that the key project variables (as volume of sales, sales price, costs) are not certain, an appraisal report is usually supplemented to include sensitivity and scenario analysis tests. Both tests are static and rather arbitrary in their nature. During the simulation process, random scenarios are built up using input values for the project's key uncertain variables, which are selected from appropriate probability distributions. The results are collected and analyzed statistically so as to arrive at a probability distribution of the potential outcomes of the project and to estimate various measures of project risk.