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Investment appraisal under uncertainty

2.3 Simulation

Simulation addresses one of the weaknesses of EVs by calculating the effect of
changes in multiple variables at a time.

It produces a distribution of the possible outcomes from the project, the probabilities
of which can then be calculated by reference to the frequencies on which they occur.

2.4 Adjusted payback

Shortening the payback period required places more emphasis on earlier (less risky)
cash flows.

2.5 Discounted payback

When calculating the payback period, the cumulative position can be calculated
using the discounted cash flows instead of the cash flows themselves. This removes
the disadvantage of payback calculations failing to take into account the time value of
money.

2.6 Risk-adjusted discount rates

Increasing the discount rate used to appraise a project will reduce its NPV. If a
project is perceived to be more risky than usual, the appraisal could therefore be
done with a higher discount rate than usual, making it harder for the project to gain a
positive NPV.

Decision makers could there be more confident that those projects that do earn a
positive NPV are worthwhile.

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