2. NPV/payback and simulation analysis

For any investment decision, it is important for financial managers to evaluate their risk exposures. There are several tools and techniques available to help financial decision makers evaluate project risk.

The Net present value / Payback (NPV/PB) approach

Some managers use the combined net present value/payback (NPV/PB) approach. In this approach, the managers might decide to a project unless it has a positive net present value and a payback of than a certain stated number of years.

If a project is expected to generate negative or very low cash flows until the payback period cutoff point but is expected to generate fairly certain positive cash flows beyond the payback period cutoff point, managers using the NPV/PB approach for decision making are likely to:

Accept the project

Reject the project

Simulation analysis

Since there are limitations to the NPV/PB approach, some managers may want to use alternative techniques to evaluate their project risk. For larger projects, some managers will employ a simulation analysis. Although it is a very expensive technique, a simulation analysis helps financial managers evaluate project riskthat is, the probability of project success or failure based on company benchmarks.

Suppose you are evaluating the risk of two major investment projects for your business firm. After all preliminary calculations and simulation iterations, youve created a probability distribution and computed the mean values for the two projects. You also have some data on the number of standard deviations (z), which tells you how far away a particular value of return or cash flow is from the expected value.

Data Collected
	Project X	Project Y
Expected net present value	$26,400	$39,600
Standard deviation	$10,000	$6,000

Probability Data for z
z	0.00	0.05
0.5	0.3085	0.2912
1.0	0.1587	0.1469
1.5	0.0668	0.0606
2.0	0.0228	0.0202

Suppose you base your investment decision on the projects standard deviation. Which project seems riskier based on this criterion?

Project X

Project Y

Alternatively, suppose you base your decision on the projects coefficient of variation. Which project seems riskier based on this criterion?

Project X

Project Y

Based on your simulation results, what is the probability that project Y will have a net present value of greater than $48,600?

30.50%

6.68%

7.49%

29.12%