Net Present Value with Uncertainty

Projects may be evaluated and compared according to the Net Present Value (NPV) of their cash flow. The NPV is the discounted expected revenues minus the costs over the lifetime of the project. Traditional NPV calculations do not take into account the uncertainty in the variables that influence the revenues and costs. We present a simulation approach to incorporate uncertainty in the NPV calculations. We build a joint stochastic model for the most influential input variables of the NPV calculation. From this model we simulate correlated scenarios of these variables and calculate the NPV. This way, the uncertainty in the input variables are transferred to the NPV calculations. The resulting probability distribution of the NPV takes into account worst-case scenarios that arise when several factors evolve in undesired directions at the same time. This allows us to measure the uncertainty associated with the NPV using confidence intervals or the Valueat-Risk (VaR).