Prof. Gautam V. Desai
Dr. Iyer Sesha R
Abstract
The value of NPV (Net Present Value) as a metric forfinancial appraisal ofprojects is well established. One important limitation of this technique is its inability to encompass the range offuture scenarios for covering the issues related to project risks. In absence of concrete data, the technique has to be applied with selection of parameters, which reflect the "best guess" judgment of the evaluator. Uncertainty and risk involved in such arbitrary choice significantly diminish the value of the metric for appraisal. Monte Carlo simulation is one method ofpartially overcoming this problem. It involves constructing a model, which would reflect the variations in the critical parameters likely to be thrown up in future scenarios. By random variation ofthe parameters in the model, NPV values in terms of the cumulative frequency or probabilistic distribution correspondingto such diverse scenarios can be developed. This would allow the evaluator to see the probability associated with any specific value of NPV in face of the unpredictable future scenarios and thus equip the decision maker with a toolfor a much more focused and objective evaluation for appraising the uncertainties and financial risks associated with the project. This article illustrates the Monte Carlo technique for simulation model using a case study, which involves a realistic business situation of making investment decision for a major new project. The detailed step-wise exposition ofthis method in this article would permit an interested reader to imbibe the essentials of this technique and apply it to his own project. There are complex proprietary software operating on special processing equipment available in the market; the important merit of the way the technique is presented in this article is that it can be applied without any compromise in the quality of the output using just a personal computer and Excel® or similar spreadsheet software. In that context, the article could be useful as a case study for classroom teaching of the quantitative project risk management technique for postgraduate level general management or special project management programs.
Keywords- NPV(Net Present Value), Monte Carlo Simulation, Project Risk Management, Quantitative Techniques for Risk Management