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

This work has been prepared for the purpose of presenting the methodology a nd uses of the Monte Carlo simulation technique as applied in the evaluatio n of investment projects to analyze and assess risk. In the deterministic a ppraisal the basic decision rule for a project is simply to accept or rejec t the project depending on whether its net present value (NPV) is positive or negative, respectively. Similarly. when choosing among alternative (mutu ally exclusive) projects, the decision rule is to select the one with the h ighest NPV, provided that it is positive. Recognizing tile fact that tile k ey project variables (as volume of sales, sales price, costs) are not certa in, an appraisal report is usually supplemented to include sensitivity and scenario analysis tests. Both tests are static and rather arbitrary in thei r nature. During the simulation process, random scenarios are built up usin g input values for the project's key uncertain variables, which are selecte d from appropriate probability distributions. The results are collected and analyzed statistically so as to arrive at a probability distribution of th e potential outcomes of the project and to estimate various measures of pro ject risk.