Investment and project valuation

Further information: Business valuation, stock valuation, and fundamental analysis

In general,[29] each project's value will be estimated using a discounted cash flow (DCF)
valuation, and the opportunity with the highest value, as measured by the resultant net present
value (NPV) will be selected (applied to Corporate Finance by Joel Dean in 1951). This requires
estimating the size and timing of all of the incremental cash flows resulting from the project.
Such future cash flows are then discounted to determine their present value (see Time value of
money). These present values are then summed, and this sum net of the initial investment
outlay is the NPV. See Financial modeling.

The NPV is greatly affected by the discount rate. Thus, identifying the proper discount rate –
often termed, the project "hurdle rate"[30] – is critical to choosing good projects and
investments for the firm. The hurdle rate is the minimum acceptable return on an investment –
i.e., the project appropriate discount rate. The hurdle rate should reflect the riskiness of the
investment, typically measured by volatility of cash flows, and must take into account the
project-relevant financing mix.[31] Managers use models such as the CAPM or the APT to
estimate a discount rate appropriate for a particular project, and use the weighted average cost
of capital (WACC) to reflect the financing mix selected. (A common error in choosing a discount
rate for a project is to apply a WACC that applies to the entire firm. Such an approach may not
be appropriate where the risk of a particular project differs markedly from that of the firm's
existing portfolio of assets.)

In conjunction with NPV, there are several other measures used as (secondary) selection criteria
in corporate finance. These are visible from the DCF and include discounted payback period, IRR,
Modified IRR, equivalent annuity, capital efficiency, and ROI. Alternatives (complements) to NPV
include Residual Income Valuation, MVA / EVA (Joel Stern, Stern Stewart & Co) and APV
(Stewart Myers). See list of valuation topics.

Valuing flexibility

Main articles: Real options analysis and decision tree

In many cases, for example R&D projects, a project may open (or close) various paths of action
to the company, but this reality will not (typically) be captured in a strict NPV approach.[32]
Some analysts account for this uncertainty by adjusting the discount rate (e.g. by increasing the
cost of capital) or the cash flows (using certainty equivalents, or applying (subjective) "haircuts"
to the forecast numbers).[33][34] Even when employed, however, these latter methods do not
normally properly account for changes in risk over the project's lifecycle and hence fail to
appropriately adapt the risk adjustment.[35] Management will therefore (sometimes) employ
tools which place an explicit value on these options. So, whereas in a DCF valuation the most
likely or average or scenario specific cash flows are discounted, here the "flexible and staged
nature" of the investment is modelled, and hence "all" potential payoffs are considered. See
further under Real options valuation. The difference between the two valuations is the "value of
flexibility" inherent in the project.

The two most common tools are Decision Tree Analysis (DTA)[36] and Real options valuation
(ROV);[37] they may often be used interchangeably:

DTA values flexibility by incorporating possible events (or states) and consequent management
decisions. (For example, a company would build a factory given that demand for its product
exceeded a certain level during the pilot-phase, and outsource production otherwise. In turn,
given further demand, it would similarly expand the factory, and maintain it otherwise. In a DCF
model, by contrast, there is no "branching" – each scenario must be modelled separately.) In the
decision tree, each management decision in response to an "event" generates a "branch" or
"path" which the company could follow; the probabilities of each event are determined or
specified by management. Once the tree is constructed: (1) "all" possible events and their
resultant paths are visible to management; (2) given this "knowledge" of the events that could
follow, and assuming rational decision making, management chooses the branches (i.e. actions)
corresponding to the highest value path probability weighted; (3) this path is then taken as
representative of project value. See Decision theory#Choice under uncertainty.

ROV is usually used when the value of a project is contingent on the value of some other asset
or underlying variable. (For example, the viability of a mining project is contingent on the price
of gold; if the price is too low, management will abandon the mining rights, if sufficiently high,
management will develop the ore body. Again, a DCF valuation would capture only one of these
outcomes.) Here: (1) using financial option theory as a framework, the decision to be taken is
identified as corresponding to either a call option or a put option; (2) an appropriate valuation
technique is then employed – usually a variant on the Binomial options model or a bespoke
simulation model, while Black Scholes type formulae are used less often; see Contingent claim
valuation. (3) The "true" value of the project is then the NPV of the "most likely" scenario plus
the option value. (Real options in corporate finance were first discussed by Stewart Myers in
1977; viewing corporate strategy as a series of options was originally per Timothy Luehrman, in
the late 1990s.) See also #Option pricing approaches under Business valuation.

Quantifying uncertainty

Further information: Sensitivity analysis, Scenario planning, and Monte Carlo methods in finance
Given the uncertainty inherent in project forecasting and valuation,[36][38] analysts will wish to
assess the sensitivity of project NPV to the various inputs (i.e. assumptions) to the DCF model. In
a typical sensitivity analysis the analyst will vary one key factor while holding all other inputs
constant, ceteris paribus. The sensitivity of NPV to a change in that factor is then observed, and
is calculated as a "slope": ΔNPV / Δfactor. For example, the analyst will determine NPV at
various growth rates in annual revenue as specified (usually at set increments, e.g. -10%, -5%,
0%, 5%....), and then determine the sensitivity using this formula. Often, several variables may
be of interest, and their various combinations produce a "value-surface",[39] (or even a "value-
space",) where NPV is then a function of several variables. See also Stress testing.

Using a related technique, analysts also run scenario based forecasts of NPV. Here, a scenario
comprises a particular outcome for economy-wide, "global" factors (demand for the product,
exchange rates, commodity prices, etc...) as well as for company-specific factors (unit costs,
etc...). As an example, the analyst may specify various revenue growth scenarios (e.g. 0% for
"Worst Case", 10% for "Likely Case" and 20% for "Best Case"), where all key inputs are adjusted
so as to be consistent with the growth assumptions, and calculate the NPV for each. Note that
for scenario based analysis, the various combinations of inputs must be internally consistent
(see discussion at Financial modeling), whereas for the sensitivity approach these need not be
so. An application of this methodology is to determine an "unbiased" NPV, where management
determines a (subjective) probability for each scenario – the NPV for the project is then the
probability-weighted average of the various scenarios; see First Chicago Method. (See also rNPV,
where cash flows, as opposed to scenarios, are probability-weighted.)

A further advancement which "overcomes the limitations of sensitivity and scenario analyses by
examining the effects of all possible combinations of variables and their realizations" [40] is to
construct stochastic[41] or probabilistic financial models – as opposed to the traditional static
and deterministic models as above.[38] For this purpose, the most common method is to use
Monte Carlo simulation to analyze the project's NPV. This method was introduced to finance by
David B. Hertz in 1964, although it has only recently become common: today analysts are even
able to run simulations in spreadsheet based DCF models, typically using a risk-analysis add-in,
such as @Risk or Crystal Ball. Here, the cash flow components that are (heavily) impacted by
uncertainty are simulated, mathematically reflecting their "random characteristics". In contrast
to the scenario approach above, the simulation produces several thousand random but possible
outcomes, or trials, "covering all conceivable real world contingencies in proportion to their
likelihood;" [42] see Monte Carlo Simulation versus "What If" Scenarios. The output is then a
histogram of project NPV, and the average NPV of the potential investment – as well as its
volatility and other sensitivities – is then observed. This histogram provides information not
visible from the static DCF: for example, it allows for an estimate of the probability that a project
has a net present value greater than zero (or any other value).
Continuing the above example: instead of assigning three discrete values to revenue growth,
and to the other relevant variables, the analyst would assign an appropriate probability
distribution to each variable (commonly triangular or beta), and, where possible, specify the
observed or supposed correlation between the variables. These distributions would then be
"sampled" repeatedly – incorporating this correlation – so as to generate several thousand
random but possible scenarios, with corresponding valuations, which are then used to generate
the NPV histogram. The resultant statistics (average NPV and standard deviation of NPV) will be
a more accurate mirror of the project's "randomness" than the variance observed under the
scenario based approach. These are often used as estimates of the underlying "spot price" and
volatility for the real option valuation as above; see Real options valuation #Valuation inputs. A
more robust Monte Carlo model would include the possible occurrence of risk events (e.g., a
credit crunch) that drive variations in one or more of the DCF model inputs.