Investment Projects under Uncertainty

An investing company expects to achieve positive results from an investment project in regard to technologies, revenues, costs and/or cash flows. Under known or predictable conditions, i.e. under certainty, these results can be determined unambiguously. However, in reality, most investment conditions must be considered uncertain.

For example, goods produced on a new machine might not achieve sales at the levels expected; expected profits from a foreign investment might not be achieved; or a rationalisation or modernisation investment might take an unexpectedly long time to impact on efficiency. This uncertainty might be caused by customer, competitor or employee behaviour, or by technical processes and cyclical declines. All uncertainties create risks concerning the target measures reached by investments and the decisions based on investment appraisal. A risk can be understood as the danger of making a wrong decision that leads to failing the targets set. A more comprehensive interpretation, which is used in this chapter, is that risk captures the possibility that the realised target values might deviate from the expected targets with either negative or positive consequences.

Because company and environmental structures are complex and fast-changing, many investment decisions involve substantial uncertainty and, consequently, high risks. These should be considered in investment decision-making, in order to protect the company and ensure its long-term development.

There are several ways of incorporating uncertainty into planning. Through information gathering and processing, data may be obtained that helps to reduce uncertainty or assists in analysing its causes or effects. Analysis and forecasting techniques (such as the scenario method) allow the causes, forms and effects of uncertainty to be clarified. Also, specific investment appraisal models and methods can be used to determine how changing company or environmental conditions may cause variations in target measures. The results of investment decisions can then be predicted for a range of expectations. Additionally, the relative significance of various company and environmental conditions can be estimated in order to determine the value of further information-gathering and processing activities.

If several alternative environmental and/or company conditions are possible, different target measures will apply to each. When no one alternative dominates over the rest, a decision problem can be solved by means of decision-theory rules or criteria. Such rules and criteria are outlined in Section 8.1. The following sections present and discuss the following methods that incorporate uncertainty and are suitable for making decisions about single investment projects:

• Risk adjusted analysis

• Sensitivity analysis

• Risk analysis

• The decision-tree method

• Options pricing models

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