When analyzing an investment project, estimating future cash flows is one of the most important steps. However, future cash flows have inherent uncertainty. There are several main methods to deal with the uncertainty of future cash flows in investment project analysis.
Sensitivity analysis to test effects of changes in variables
One common method is sensitivity analysis. It tests how projected cash flows and NPV would change based on changes in key variables like sales prices, sales volume, costs, etc. By changing one variable at a time and seeing the impact on NPV, it shows which variables most affect the viability of the investment project and cash flows. If the NPV remains robust across likely ranges for the variables, it gives more confidence to move ahead with the project.
Scenario analysis for different combinations of projections
Another method is scenario analysis. It looks at multiple scenarios representing different combinations of cash flow projections based on more optimistic, pessimistic, and base case assumptions for the key value drivers. Seeing the range of possible NPV outcomes across the scenarios helps assess the riskiness of the investment project and potential cash flows.
Simulations for probability distributions of projections
More advanced methods utilize simulations. Unlike sensitivity and scenario analysis which vary one or a set of inputs, simulations allow every input to vary based on a probability distribution. Running multiple simulations provides a probabilistic range for the potential NPV, giving management information on the likelihood and riskiness of certain cash flow projections for the capital investment project.
When future cash flows for an investment project are uncertain, common analytical methods like sensitivity analysis, scenario analysis and simulations help provide ranges and probabilities for the potential outcomes, allowing for more informed decision making.