When analyzing potential investment projects, the future cash flows are often uncertain. This creates risks that need to be managed carefully. There are several techniques commonly used by investors and financial analysts to address uncertain future cash flows when assessing investment projects.
Conduct scenario analysis to model different outcomes
One approach is to develop optimistic, pessimistic, and most likely scenarios for the project’s future cash flows. By analyzing the investment’s net present value and internal rate of return under each scenario, the range of potential outcomes can be assessed. This highlights downside risks and helps determine whether the project is robust across various environments.
Run sensitivity analysis on key variables
Another technique is to perform sensitivity analysis on the major value drivers and assumptions, like revenue growth rate, profit margins, cost of capital etc. By varying these inputs, investors can see how sensitive NPV and IRR are to changes in the projections. This quantifies the riskiness of the investment.
Adjust discount rates based on risk levels
Rather than taking the cost of capital as a fixed input, investors may increase discount rates for riskier cash flow projections to capture the higher return requirements. A project expected to deliver volatile cash flows would use a higher discount rate versus one with stable returns.
Utilize probability distributions for inputs
For a more rigorous quantitative analysis, key inputs can be modeled as probability distributions rather than discrete scenarios. This better reflects the range of potential outcomes and likelihoods. Monte Carlo simulation can then be used to generate multiple combinations of the variables and assess the probabilities.
Diversify investments across projects
At a portfolio level, investing in multiple projects with imperfectly correlated cash flows can reduce overall risk through diversification. A portfolio of projects with offsetting risk profiles will be more robust than concentrating in a single investment.
In summary, techniques like scenario analysis, sensitivity analysis, adjusting discount rates, using probability distributions and diversifying across projects can help manage the risks posed by uncertain future cash flows when analyzing investments.