N P V-AT-RISK M ETHOD IN I NFRASTR UCTURE P ROJECT

INVESTMENT Ev ALUA TIO N

By Sudong Ve' and Robert L. K. T iong2

AeSTRACT: Strategic capital invcstmcll( deci sions are crucial to a business fiml. The decision LO invest in
ptivate ly nnanced infrastructurc projects requ ires careful consideralion, because they are exposed la hi gh levcls
of financia), political. and rnarket ri sks. The projecl appraisaJ melhods shou ld incorporare .malysis of these risks.
A number of capita l-in vestment decision methods ca n take risks into aCCOUnl, bOl each of thcm racuses on
different factors and has ilS limitations. Thus, a more vigorous melhad is needed. A syslernatic c1assific3tion of
exislin g evaJuation rnelhods shows th al it is possible 10 develop a ncw mcthad - the net-present-valu e-at-risk
(NPV-ut-n sk) mcthod-by combining lhe we ighted average cost of capital and dU~ll risk-relUm methods. Thc
eval uation of two hYPolhelical power projects shows that lhe NPV-at-risk method can provide <1 betler decision
for risk evalualion of. and in veslment in, privately fin anced infrastnlc(ure projects.

INTRODUCTION
Strategic capital inves tment decisions are crucial lo a busi-
ness finn. The decision lo become involved in privalely fi-
nanced infraslruclUre projects such as a build-operate-transfer
(BOT) power plant or a 1011 road requires careful consideralion
and thorough analysis. Traditionally, investmen t decisions on
infrastructure projecls are made by the invesling govemmenl
based on lhe benefit-cost analysis and economic viabi lity of
lhe projects. BUl lhe BOT procurement strategy separates fi -
nancial benefits from economic benefits. because lhe primary
objective of lhe private sector is to maximi ze profits. and Iheir
decisions are mainly based on the financia l viability of proj-
ects.
The 01051 com mon methods for the assessment of financ ial
viabiJüy are Ihe payback period, average accounting rate of
retum, the net present val ue (N PV). and lhe intemal rale of
retum (IRR) melhods. Decisions den ved from these melhods
are based on Lhe forecasls of base-case cash Hows. Howeve r,
BOT infrasLructure projects are characterized by high capiLal
olltlays, long lead times. and long operating períods. These
characteristics make lhe forecasts of cash Hows more difficult
and ex pose the private sec tor to high levels of financial, po.
litica!. and markeL risks. This requires the decision te incor·
parare risk analysis into project appraisal methods.
The comino n methods of incorporating ri sk into capi tal· in-
veSlment decisions are Lhe dual ri sk-return and the ri sk-ad-
justed discount rate methods. They focus either on measuring
risk or deterrnining discount rales. The dual ri sk-relUen method
is limited by difficully in determinin g Ihe size of acceptable
deviation, while the ri sk-adj usled discou nl rate melhod failed
to provide lhe confidence level of its res ulls. Funhermore,
since financing is a key element of BOT projects. investment
decisions al50 should take financing melhods into accounl.
Therefore. a more vigoro us investment decision method thal
incorporates bolh ri5k and financing methods is needed.
The need for a more vigorous Illethod was highl ighted by
lhe recent Southeast Asia financ ial cri sis. A nUlllber of BOT
projects suffered disastrous consequences. Some BOT projecls
under construclion had been postponed or abandoned by lhe
IRes. Scholar. elf. for Advanced Conste. Studies. Nanyang Technol.
Univ.• Singapore.
"lAssoc. Pro!".. Ctr. for Advanced ConSlr. SlUdies. Nanynng Technol.
Univ .. Singapore .
Note. Discussion open until Novcmber l. 2000. To extend me dosing
dale one monlh. a wrinen requcsl musl be filed wi lh the ASCE Manager
of Journa ls. The manuscripl for this paper was submiued for review and
possible publicalion on February 2. 1999. This papcr is pan of [he Jour.
"al 01 ConSlruclion Engineering alld M a"agemellt. Vol. 126. No . 3.
M ay/June. 2000. <C ASCE. t SSN 0733-9634/00/0003-0227 - 0233/$8.00 +
$.50 pcr page. Paper No. 20186.
JOURNAL OF CONSTRUCTlON ENGINEERING ANO MANAGEMENT / MAY/JUNE 2000 / 227
prol1loters. and others had 10 be bailed out by the host gov-
emments. ProjecI s in operation also suffered huge losses re·
su lt ing from such factors as the deprec iation of local curren-
eies or red uct ion in lariffs by utilities. The experience
increased lhe need to seek more powerful meLhods of address-
ing risk in investmem decision maJ...;n g. This paper deveJops
a new project evaluauon melhod called me NPV-at-risk and
attempts 10 show !hai Lhis method can potentially Qvercome
these problems in investmelll decision making.
METHODS OF CAPITAL INVESTMENT DECISION
MAKING
The project eval uati on mclhods may systematically be clas-
sified inlo three categories: melhods based 011 relurn, Illethods
based on ri sk, and melhods based both on retum and risk (Fig.
1). The meLhods based on reLUrn inelude Ihe payback period,
Lhe average accounling rate of relUm (a lso caBed lhe reruen on
ca pi,al employed), NPY. and IRR. The payback period and the
average accounting rale of relu.m melhods igno re the time
value of money, whereas NPV and IRR melhods incorpora te
the time value af 11l0ney imo decision making usi ng dis-
counled cash How lechniques. But all of lhem are based on
the assumplion that lhe cash Hows of Lhe project are certain,
whereas lhe project's actual cash ftows co uld differ substan-
tially from lhe forecas! cas h Hows.
The unce rtainlies bring risk into capital in veslment evalua-
lion decisions. This directs allenlion 10 lhe development of
ri sk·rating systems. In risk-raling systems, an investmenl is
evaluated and assigned a grade of risk ratings. The ratings are
divided into in vestm ent and speculati ve grades. The decision
ru le is that lhe projecl is e ligible for investment ir it is r::J.ted
one of lhe investment grades. for example. BBS or aboye in
Standard & Poor's ratings or Saa or aboye in Moody 's ratings.
The ralings are inte nded to measure credil risk, 1101 other forms
of in vestment risk (S timpson 199 1l. They pertain to invest-
ment qua.lity. nOl inveSlment attractiveness (Hen nessy 1986).
InveSlors must detennine their Qwn requi red return s.
The inadequacies of a decision criterio n based solely on
relUrn or ri sk show 1hal methods incorporaling ri sk inlo the
measuremcnl of retum should be developed. The most com-
mon melhods are lhe risk-adjusted discount r..tle mcthods such
as Capital Asse, Pricing Model (CAPM). arbitrage pricing the-
ory (APT), and ,he weighted average cos, of capital (WACC).
They focus on lhe determination of discoul1l mtes under un-
certainties. The phi losophy of lhese mClhods is lhal Lhe risk-
adjusled di scount rate should cons.isl of ri sk-free rate and risk
premium. A major problem with lhe mcthods is lhal lhere is
no indication 01' confidence level on lhe delermined discounl
rate o
An allemalive approach is probabilistic and statisti cal anal-
yses. This leads 10 developmem of dceision lTees, mean-vari-
 Considera rions (1) Consideratians (2) Decision Mechad and Decisian Rules

Payhack pcriod
Tune value (Thc shorter. lhe bcuer)
(Ignored) Average aecountmg rate oC rerum
Retum (Grearer Ihan Ihe rcquircd rale)
(Considcrcd) Internal rale oC return (IRR)
Ti me value "j (Grcater Ihan Ihe rcquircd mle)
(Considcrcd) L-\ Nel preselll va,lue (m mimmum Moua l rale of relum)
(Grealer Ihan zero)

Riskprefcrences Uulily th/"'Ory

(Considercd) CIñe gre.alcr me cxpected utility, Ihe bcucr)

Cumulative dislrtbution analys is

AII possiblc oUlcom~

/ (FirstlSeeond Dcb>TCe SlochaSlic Dominance)
Decision TreesiExp~Clcd RClUm
(The expeclcd NPV>O)
(Considercd) ~ MC'an RClum ..• Variance (cr)
\. \ (The grealer rcmm 3nd Imer 0', Ihe beller)
\, Mean RelUm ._- Coefficient of Varialion
,, (The gtCaler relUm and Icsser cr/~. lhe beucr)
,,
~ NPV·al-risk
RClum & risks r
O ,I (NPV-at-risk al spccificd confidence level >0)
(Con... idcrcd) L...
,,
,
FlIlanc ing mClbods re NPV al discounl mle delennined by WACC
(Considcrcd) (NPV i~ greater Ihan zcro)
Financing side effccts APV value sySlem
(Collsidcred) ~
(APV is grcaler lhan zero)
Syslemalic nsk NI)V al discount rule dClCIIDlIled by CAPM
(Coosldered) (l\rpy is greater man zero)
Any number of risks NPV al dlscounl rote delcmuned bv APT
(Considcred) (NPY is greater tban zero)
Markel risk Value-at-Risk systems
(Considered) (Value-al-R isk al a given confidencc < allowablc Joss)
Toml risk NPV al discount rate delennined by managemcnl
(Considered ) (lI-rpV is greater than zero)

Rlsk Credit ri ...k Risk raling syslems

(Consldercd) ~ Considcrcd > lnveslment grade if ex p eClcd relum is satisfaclory)

FIG. 1. Methods and Decislon Rules tor Capltallnvestment Decisions

ance and cxpec lcd rcwrn-cocfficient 01' va ri ation mClhod s. nnd
c umul mive di~tr i bution ana!y sis. Decis ion-lrce analysis pro-
duces lhe weightcd average or lhe possible rcturns. weighted
by ll1C probability of the relUm occurrencc. Th is melhod ig-
nores Ihe di~persion 01' rClums. The mean-varian ce 3nd lhe
expeclcd rt!Lum-cocfl-icicnt 01' variation Illclhods J11eas urc re-
turo ~111d risk separale ly. T hcir method is to compute lhe ex-
pccled return as Ihe rnca:-.urcmenl 01" relurn on d lhe ... izc of
devialio!1 from Ihe expec lcd rcturn a:-, Ihe mcas uremen l of risk.
They have dirticulty delCfmining Ihe :-.ize of Ihe a ll owable de-
vial ion. The cumu lati vc di~lr i blltion <1nalysis is used for ana-
Iyzing muwally exc llI ~ i ve invesunenls by comparing [heir en-
tire cU1l1ulative dis{ribution~ ol' poss ibl e rCl um s.
AnOlher J11cLhod taki ng rClurn ilnd risk inlo accounl ~im lll ­
laneoll~ly is lhe ulility theory. inc llld ing the expccted utility
model und lhe gencrali¿cd cxpcclcd utility mode l. Thc ex-
pecled uli!ity is the wcightcd average of the ulilit ies 01' the
possible oulcomc whcre lhe we ig hts are lhe objecti ve proba-
bilitieo;; 01' c~lch Olllcome. The clecisioll cri terion is tha! lhe
grca ter Ihe expec lcd lIlilily. the better the pl'ojecl. This J11clhod
involvc~ :-.ubjeclivity in conr., lfllcting approp riate utilily func-
lions. which ~re ba:-.cd on individual risk preferences. As ..1
resu lt, Ihe operationaJ micf'ulne:-.:-. 01' the expecLe d utilily model
is sevcrely Jimited (Lumby 1984).
Thc v¡lIuc-at-risk syMems providc :l decision cri te rion wilh
a confidence levc!. However. Lh ey were fina developcd for
dea lillg wilh markel risks and extended lo dcal Wilh other risks
sueh as credil, liquitl ily, and cas h Ilow (Dowd 1998), FlIrthcr-
more. they do nOI take nn3ncing I11cthods and lime value inlo
con~ i deralion. Adju:-.ICd presenl va luc (A PV) can h;:tnd le finan-
cia ! side cffcc~. Thc fundamcnLnl idea behind APV i~ lO un-
bundle componcnt\ 01' valuc. analy7e each separalcly, and then
add Ihcl11 back up (Luchrman 1997). 11 lhcrcrore providcs
more deta iled info rma li o n lhan WACC. bUI il (lIso fails LO pro-
vide a confidencc leve !.
The systematic cJassificati oll ~ h ow\ tha t a Illore ri gorous
mClhod 10 consider lhe Lim e va lu e o!" ~dJ Lhe pos~ible QUICOmes
and fillancing mClhuds in a dccisioll-muking proccss is bolh
necessary and possible. Dne of lhe possible approache~ is LO
~y nth es i ze lhe \VACe and lhe cxpectcd NPV m c thod togclher
10 fonn a minimum cxpccted NPV. This Icads 10 lhe dcvcl-
opmenl uf lhe NPV-at-rbk mcthod.

228 / JOURNAL OF CONSTRUCTION ENGINEERING AND MANAGEMENT / MAY/JUNE 2000

 Probability
1.
P(NPV<NPV,.) ·
FIG. 2. Calculation 01 NPV-at-Risk and Confidence Level Based on Probability Oistrlbution Function
DEVELOPMENT OF NPV-AT-RISK METHOD
Q ne of lhe six definitions of ri sk listed by Vl ek and Stall en
(1981) is lhal risk is lhe scmjvariance o f lhe di stribution o f a ll
consequcnces. laken oyer negative conscquences o nl y. n.nd
Wilh rcspeCI lO sorne adoptcd reference va llIC. The sCll1i vari-
ance alone as lhe mca!)urc o f risk is n OI su ffi cicllt lO make a
deci s ioll. bu! iI can be comb ined wilh lhe cx pected NPV lo
foml a new dec ision rule-a project is acccptable ir lhe mea n
NPY minus lhe stand ard deviat ion is grea ter lh an zero. How-
ever. lhis decision rule rai ls to provide decision-1l1akers with
a co nfidence Icvel. Instead of calcu lating lhe mean NPV and
standard devimion, lhe NPV at a g ivc n co nfid ence level is
<.1
computcd so thal lhe dec ision rule is tha! the proj cct is ac-
ce ptable with lhe given confidence level ir Ihe NPV .. is g rea ler
than zero. 8ased on thi s co ns ider;uion. NPV-3ot-risk is defi ned
as a pan iCllJar NPV 1.1131 is genera led from i1 projecl al somc
specific confiuence leve\. thal is, the mínimum expected NPV
wilh lhe given confidente level. In Olher words. NPV·at-risk
is Ihe value al which a % of possible NPVs are small er and 1
- et% were larger.
According to lhe de linilíon 01' NPV-al-risk. the following
decision rules can be derived: lhe project is acccplable w ith a
confidence level o f I - ex ir NPV-at-risk at lhe g iven confi -
dence is greatcr than zero: otherwisc. il is unaccclllable. AI-
tcrnati vely. Ihe projec l is acceptab le if lhe compUled confi-
dence leve l •.H Ihe poinl of zero NPV is equal loor greater
lhan Ihe predetenni ned confidence level: oth erwise, it is un-
acceplable.
The NPV-at-risk mClhod aims to calc ulale the value that Ihe
projcct's NPVs wi ll be g realer than. WiLh Lhe probability co r-
respond ing to lh e g iven co nfidence level. Il in vo lvcs the de-
termination 01' discount mte 3nd Ihe ge neration 01' cumulati ve
distribu ti on 01" poss ible NPVs. To calculate NPV. the key tas k
is to detennine an appropri ate discounl rate . T here are various
melhods of delerminin g a discoun t rateo cac h of which has its
own application. Since lhe portfolio theo ry and s ubseqlle nt
CAPM model. and APT \Vere deve loped for financial markets.
their appl icatioll 10 sland-alone projecls su tTers from the dif-
ficulty in delerlllining appropriale beta. Mo reover. lhe di scollnt
rale detcrmi ned by lhese melhods may overc mphas ize (do ubl e-
count) lhe illlpact 01' risk ex pos ure beC311se the NPV-at-risk
melhod will also takc Lhe ri sk into accounl.
Unlike CAPM and APT. WACC is Ihe cost 01' vario us fi -
nancial sou rces weightcd by Ihe ir correspo ndin g proportions
in the overall poo l of financing. The COS I of a financiaJ source
is the return expecled by investors . According lo Tiong ( 1995).
the equity of a BOT projcct is usuall y about 20- 30% of total
inves lmen l. and Ihe rcmainde r is debl fi nance. T he cquily re-
quired return i ~ asslImed to be lhe hu rd le rale o r sponsors,
JOURNAL OF CONSTRUCTtON ENGINEE RING ANO MANAGEMENT 1 MAY/JUNE 2000/ 229
NPVa
J_. f(x)dx = a
NPV
C umuJative
Probability
1.0 ----- ----_._---------_._-----_._--- ----_._----
0.5
F(NPV..>", a
a "" F{O} (l
o NPV a NPV
FIG. 3. Calculation 01 NPV-at-Risk and Confidence Level
Based on Cumulatlve Olstribution Function
whereas lhe debt req uired relurn is a~s ulll ed la be th e average
markel imereSI rateo Delermincd in thi~ way. WACC does not
surfici enLl y rc HecL lhe req uircd ri sk premium. Morcove r. ac-
cording to Farid et al. ( 1989). WACC is the o nl y practicable
opLio n at lhe present time . 8tH lhal does n Ol mean Lhal WACC
alone is good a l handling risk. Therefo re. the lI se of WACC
fo r detcrminin g the discount cate in lhe NPV-al-risk method is
p racticable withou t overestim aling ri sk. ln add ition. WACC
enables Lh e NP V-al -ri sk meLhod lO lake financing mClhods into
accounl.
According 10 Lhe requ irements of decis ion rul es. Ihere are
t\Vo appro3oches lo in veSlment decis ion makíng. the calc lll al ion
01' NPV i.1I a give n co nfide nce level and Lhe calc ul alion of a
confidence level al Ih e poinl of zero NPY. Ass umin g lhat lhe
probabi lity density function of retum is .f(N PV). N PV-at-ri sk
al a g iven confidence C( is compuled by maki ng Ihe imcgralion
between -O') an d NPV .. equ a l a. and lh e co nfide nce leve l al
the poinL 01' zero NPV is oblained by integrati on between - x
and O (Fig. 2). When the projec'-s NPVs are normall y di strib-
uted, lhe NPV-ul-risk ca n be obtain ed Ihrough lhe mean-var i-
ance melhod. In lhi s case, NPV-al-risk is the differencc of the
mean va lue and a mu hi plc of standard deviation. 1t can be
expressed as devialions from lhe mean NPV in units 01' ,-he
standard deviat io n
NPV-al-risk = mean NPV - Z(O:)'O'
where Z(a) = num be r of units al' standard deviaLion corre-
spondi ng to lhe givc n confidence level of a: for eX3 l11pl e. aL
lhe 95% confidence 1evel. Z(o:) = 1.65 . 111is means that 95%
o f possible o utcomcs faH wi thin th e range fro l11 J..L - 1.650-
lo oo.
A llcrnativcly. ass uming lhat the cumul alive distribulion
 C umulative
Probability

0.5 \.- F,(NPV) ~ (ffNPV, <~ NPV)/n

The confidence level Value af NPV -at-Risk
at lhe point of zera NPV alconfidence levelofl-a

o + NPV
FIG. 4. Calculatlon of NPV-at-Risk and Confidence Leve! Based on Simu!ation-Generated Distribution

function of rClUrn is F(NPY), NPV-at-risk al a givcn confi- TABLE 1. Base-Case Net Cash Flows before Tax ($ million)
dence ('( and lhe confidence level at the point of zero NPV ca n Nat eash
be obtained lIsing percen lile analysis on lhe cumul ative dislri - Capital Sale O&M Operaling flows
bU lio n (Fig. 3). Ir Ihe d iSlribuli on fun Clions o f relllrn,f(N PY) Year expenditure revenue oosl ¡neome before tax
or F(NPV). are unknown. Monte Carl a simulalion can be used (1) (2) (3) (4) (5) (6)
to generalc Ihe di stribuli on 01' possible NPVs. 1I takes sa mplcs I 123 O O O - 123
from th e inpuI variabl e di stributions and evaluates the corre- 2 249 O O O - 249
3 201 O O O - 201
spond ing NPY Ihal is a flln cLi on 01' these variables. The pro- 4 62 171.696 60.0936 111.6024 49.6024
cess is repcated as many times as dcsired and Ihe res ulti ng 5 O 343.392 120.1812 223.2048 223.2WS
NPV\. NPY 1 • . . . , NPV" are placed in asce nding order to ob- 6 O 343.392 120. 1872 223.2048 223.2048
7 O 343.392- 120. 1812 223.2048 223.2048
win (he CUI11U I<l live distribu lio n 01' NPV The di stribution fune- 8 O 343.392 120. 1872 223.2048 223.2048
lion can be eSli mated by Ihe c mpiri cal di stribul ion func tion 9 O 343.392 120. 1872 223.'2048 223.2048
F"(N PY) = (#NPY, s; NPY)/n, wh ieh is the re lali ve freqlleney 10 O 343 .392 120.1872 223.2048 223.2048
11 O 343.392 120. 1872 223.2048 223.2048
01' NPV. wherc #NPY, is lhe numbc r 01' simulation outputs, 12 O 34.l392 120. 1872 223.2048 223.2048
NPY¡, NPV !..... NPVm Ihat are no grealer lhan lhe speciflcd tJ O 343. 392 120.1872 223.2048 223.2048
NPY. Tilus. NPV-at-risk at a gíven confidence level can be 14 O 343.392 120.1872 223.2048 223.2048
15 O 343.392 120. 1871 223.2048 223.2048
obtained by calclllaLing lhe percenlil e F,~ '(('() = NPY". and lhe
16 O 343.392 120. 1871 223.2048 223.2W8
con ride nce level at the point 01' ze ro NPV can be obtained by t7 O 343.392 120. 1872 223.2048 223.2048
complIling Ihe probabililY of NPV s O, thal is, F,,(O) = (#N PY, 18 O 343.392 1'20. 1872 223.2048 223.2048
::s:; 0)/1/. Fig. 4 shows the calculatíon of NPY-at-risk at a given 19 O 343.392 120.1872 223.2048 223.2048
20 O 343.392- 120. 1872 223.2048 223.2048
confidcnce level and the confldence leve l al the poinl of zero Tl11al 635 5.665.968 1,983.0SlJ 3,682.879 3.047.879
NPV rrom Lhe cmpirical c umulative dis Lribu tion rllnction NOle: Sale rc\'cnue = 80% mstal1ed caprlclly X 365 x 24 X sel1i ng pncc = 0.8
F,,(NPY). X 700.000 X ]65 X 24 X Q. 07 = 343 .392 millioll. O&M coSt = 35% sale l1!\'cnuc.
Obtaincd in thi s way NPY-at-risk is subject to estimation Opcrating incolllc = sale rc.\'enue - O&M cos\.
error resu hi ng frol11 sampling crror, inappropriate di scouI11
ratc. and inappropri<tte cash How mode!. Thcrefore, lhere is a
need lO validale its reliab il ity. One approach is to use Kol - single values of variables. In fact, the variab les, such as COI11-
l11ogorov co nfide nce ballds as lhe confidence bands as lhe co n- plelion time, co nstruction cost, marke1 dcmand, sale price, op-
fidence bands for th e emp irical clll1llllativc di stribution. The e rali oll and maintenance (O&M) COSlS, inHation, foreign
confidence bands ca n be obtai lled by do.n ;; d",h./n, whic h dc- exc hange raleo and interest rateo are uncertain. The uncertain-
pends lIpon borh Ihe eonfide nce level I - a and the sample ti es of lhese vari ables mean that they can be tremed as 510-
size. chastic vari ables (or "stale vari ab les"). Monte Cario simula-
ti on can be applied (o determine the distribution of NPY, given
APPLlCATION OF NPV-AT-RISK that the probability distribution of eac h vari able is known. The
probabilily distriblltions of the completion lime, const"ruction
To del110nslrale lhe app licalion 01' Ihe NPY-at-risk method , cost. and O&M costs can be detcrmined from ex perie nce of
IwO hypothelical powcr projects, Plants A and B, are evalu- similar projects in approximately similar conditions. Here,
ateó. 80Lh projec ts have lhe sa mc size (2 X 350 MW turbine- lhey are assumed as lognormal di stributions ()J., O"~). The log-
genenHor un its), bUI are located in countries wi lh different normal assu mpti ons are based 0 11 Ihe intui lio n lhaL l.he eXlenl
degrees of political unCeltainly. They are proclIred under BOT of costsaving and timesaving is limited, whereas the ex tent of
con trocl wi th a concession period of 20 years. The base-case COSI overrUll and time overrun i5 in finile. The probability di s-
cash fl ows of the projccls are derived on the followi ng as- tribllti on5 of the market demando sale price, and inftat.ion. for-
sumptions. The building of a 2 X 350 M-W power plant re- eign exchange. and imeresl rates C3 n be dete rmined by col-
quires $635,000.000 ove r 3.5 years. Duling ilS ope raliol1 pe- lecling and analyz.ing cconomic data of lhe host countries.
ri od. the average demand is 80% 01' inslalled capacity al lhe Here, lhey are assumed as nonnal di stlibuti olls (J-L, 0"1). The
larirr 01' $O.07/kW· h. The operation and mainlenance cost is mea n IJ. of dislributi on func tion of a variab le is assllmed Lo be
35% of OUlpUl. The debl-equ ity ratio is 3. wilh an annual debl lhe estimated value of Ihe vari able in base case. The coefficient
interest rate 01' 9% and compuny 's hurdle Hite of 12%/year. of vari ance (Co V) of variables in Plant A is assul1lcd to be
The cxchange raLe o f Ihe local c urrency for U.S. dollar is 1. 0.1, so the standard deviation O" will be O. I~ . Ass ume Plant
The estimated base-case cash ftows are sllowll in Table l . B has more unccI1ail1l y and Ihe CaV of its variabl es is twi ce
Thc base-case net cash Hows befare tax are eslimaled from as much as thal 01' Plan l A's. The standard deviation of its
230 I JOURNAL OF CONSTRUCTION ENGINEERlNG AND MANAGEMENT I MAY/JUNE 2000
 TABLE 2 Param eters and Types of Dlstribution of Key Rlsk Facto rs

Plant A Plant B
Distributional Estimated mean CoY SO CoY SO
Variable assumption (",) "1,,, (,,) "1,,, (,,)
(1 ) (2) (3) (4) (5) (6) (7)
Conslruction co!"t lúgnormal (~. 11~ ) 500.000.000 0.1 50 0.2 100
Complclion time Jognormal ( .... , (11 ) 3.5 year.;: 0.1 0.4 0.2 0.8
O&M cnsl logn ormal (f,L, u ' ) 35 % of sale 0.1 0.035 0.2 0.07
Markel del1l<lnd normal <..... (J?) 560 MW 0. 1 56 0.2 11 2
Sa le price normal (~. (J"~ ) $0.07iKW · h 0. 1 0.006 0.2 0.0123
ln tlalion nHe norma l { ~. (J" ! ) 2% pcr ¡¡nnum 0.1 0.002 0.2 0.004
Forcign cxdmnge rale normal (~. (1 2 ) 1.0 0. 1 0. 1 0.2 0.2
¡meresl ru te norma l (¡J.. a !) 9% per .l/mUEn 0. 1 0.009 0.2 0.018

PlantA
1.2
(~=415.2. (J = 227 .5 )

.~
/
.-.. #- ...-,
:E
.•
.Q

.~
o
"
~
0.8
Plant B
(¡, = 418.6. (J = 477 .8)
;; 0.6
;;
e
u= DA
0.19

0.024 0.05

-1500 -1000 69 500 1000 1500 2000 2500

-302
Value of NPV ($ m iUion)

FI G. 5. Com pari s on of NPV Oistribution s at Plant s A an d B

v¡lriab les will be 0.2¡.t.. DiSlribulions 01' the variables are given
in Table 2.
A Monte Cario simulatiol1 01' 1.000 iteralions was carri ed
out on a simlllation made l developed by the writers 10 oblain
the distribuJion ofNPV for PI"ms A and B, respectively. Based
on the generated cumulative di slribution 0 1" Planl A s NPV, it
can be compu led that NPV-at-risk of Plant A al 95% confi-
de nce level is $69,000,000. Bccause NPV-al-risk 01' Plum A is
greater than ze ro, Lhe projecLis investable. Alternatively, il ca n
be compUlcd lhat ¡he probabil ily al lhe point of zero NPV is
0.024. In oth er words. there is 97.6% confide nce Ihm NPV is
grcé.ller than zero. This confidence level is grealer Ihan Ihe
predctcnnined confidence level of 95%, so lhis project is in-
vestable. These IwO approaches have lhe same conclusion.
Simi larl y. il can be com puted that NPV-at-risk of Pla nt B al
95% confid ence level is -$302.000,000 and 0.19 probabilily
al the point of zero NPV. Thus. Plam B is nOl investable. The
sim ulmi on res ulls are shown in Fig. 5. Ir the debt-equity rat io
of Planl B decreases fTom 3 lO 0.25. ilS NPV-at-risk will in-
crease from -$302.000,000 10 $5 1,000,000. Plan l B becomes
inveslablc. This is because lhe sponsor bears Ihe major part of
ri sk in me fo rm of equily investment. That is why a riskier
projecl oflen requires more eq uil y invest menl.
COMPARISON OF EVALUATION METHODS
The methods indicated in Fi g. I ha ve their o\V n dala rc-
qu iremenls such as base-case cash ftow s. stalislical dala, and
simu lations.
Based on the base-case cash fl ows. lhe payback pcriod for
berh projecls is 6.4 years. This method lhus can nOI di stinguish
JOURNAL OF CONSTRUCTION ENGINEERING AND MANAGEMENT i MAYiJUNE 2000 i 231
which project is preferable. S imilarly, lhe accounting rate of
return and IRR methods cannOI di stinguish belween Lhe IWO
projects. alLhough Lhe returns are grealer than lhe hurdle nlle
of 12% . Bo t.h NPV at Ihe minimum annllal rale of retum and
NPV al the di scount mle of WACC eannot dislinguish between
the t\Vo projecls. bUl show Ihal bOlh projects are investab le
beeallse their NPYs are greater th an zero. The hypoLhetkal
projects were nOl evalllaled by the APV me thod and the meth-
od::; caJculati ng NPV al discount rates detennined by CAPM,
APT, and lhe management. because Ihey require more infar-
mation besides ba se~case cash nows.
Baseu on lhe sume si mulation dma. lhe expected return
method co ncludes thal Plant B is preferab le lO Plant A and
that both plan ts are in ves table because lheir expected NPVs
are greater lhan zero. The mea n-vari ance melhod providcs
oll ly two numbers. mean NPV and standard deviation. AI-
though mean NPV is greater than zera. lhe method cannot
decide whelher Ihe projecls are inveslable. bec3use lhe deci -
sion depends on the trade-off between ri sk and rentrn. 1t also
fuiled to di stingu ish whieh is preferable. because bOlh the
mean and variance of Planl B are grealCr lhan lheir CQunler-
parts far Plant A. The mean CaV melhod is better Ihan the
mean ~va rian ce melhod, because il ca n judge lhe preferred proj-
eCl (Le .. Plant A), but il fai led lO make a decision. The cu-
l11u lative di stribuLÍon ana lys is canllol make a decision . It also
experienced difficully in dj slingui shin g (he preferablc project.
Table 3 tabula res the res ults of different evaluation methods .
COl11pared wi th the NPV-at-risk melhod, lhe met hods based on
b~lse-case cash Hows failed either to lake ri sk imo accounl
(e.g., pnyback period) or to handle random variables if ri sk is
co nsidered (e.g., NPV al a discoulll rate delermincd by
 TABLE 3 Comparison of Different Evaluation Methods

Analysis Results
Evaluation method PlantA Plant B Decision Remarks
(1 ) (2) (3) (4) (4)
1>'lyback periou 6.4 yC:lrs 6A years Plao! A is same as PllIIH B. In vestabi lity Base-casc cash Rows are rcquireu. Cal-
dcpcnds on e:<pcricllce. culalion h. si mple.
Accouming rale o f reUlrn 23.5% 23.5 % Plarl1 A b sa me .15 Pta.lt B. Inveslabi lily Base-case cash nows are rc<] uired.
dcpcnds un prCdCIl!nnined hurdle rale.
lmemal rate of rClum 26Cff 26t;~· Pl ánt A i ~ smne as Plant B. In ve!:aability B'lse-c.:usc. cash flnws are req uired . Cal-
depends on prcdt:lermined hurdl c rute. culmion i1; complexo
N PV 5569.000,000 $569,000,000 Planl A is same as Plan! B. Both proj- Bu:;e-c .. se cash fl ows and di:;counl nue
eets are invcstnble (N PV > O). are required (Discounl !'ate = 0.12.
i.e .. eompany's hurdle mte).
NPV (WACC discnu l1 l $785,000.000 $7&5.000,000 Plant A jli s.¡¡mc as Planl B bccausc ¡hey Base-case cash flow s. and informmion
[(IIC) have s<.\ mc cupital structure tlnd irllcr- on capital slruCture. debt interest rute
eSI rate. Buth are in vcstable (NPV > :.md equity rClUm are required. (eq uity
01. rClunl = comp:my's hurdl e ratc)
NPV-al-ri:<k 569.000.000 - $302.000.000 Pla nt A is inveslablc. bu! Plnlll B is nol. Distribulion of NPV is required. Diffi-
b:l<;ed t) n 95<ft 01' confidence. c ulty in evalu ating pro bability d istri -
bUlions (lf variables.
CUlllu lélti"c distribution Fig.4 Fig.5 Plan! A is prcfcrablc lO Plant B for risk- Distribu¡ioll of NPV is requ ired. Difli -
analysis ¡¡verse invc,>tor~. BUI lhis doc~ nOI cull)' in imerpreting Iheir re:-'lrlt s whe n
meun 111<11 Pb nt A is in\'c!.t~tb l c. lWQ cumulali ve <.Ii slríbuti o ns interscct.
Dec ision Irce/ex pec led rc- $415,200,000 $4 18.200,000 Pl aTll B' ~ NPV is g reater Ihan Plam A·s. AII possible oulcomes :.md Iheir proba-
IUrn Both are invcsl¡¡blc bccausc- NPV > O. bilitics are rcquired. Diffic ulty in cva l ~
uali ng probabilily of ou tcomc.
Mean rc turn ~ "a rian cc ~ = 415.2 JJ. = 418.6 Bo th phllllS have posili"e cx pecled NPV. Dislribulion of NPV is retluired. Diffi-
(1 = 227.5 <T = 477.8 bUI is risk acceptablc? Decision:, dc- cu ll'y in c-vn luuling probabililY distri-
pend on risk-relurn lrude-off. bUlions of variables and trade-off be-
Iwecn risk and rctUnl .
Mea n return-CoV J-I. = 415.2 JJ. = . H8.6 Plant A is prefcruble to Plant B. Dcci- Distribulio n of NPV is req uircd. Dirfi -
0'/1' = 0.55 fT/J).= 1.1-t siolls depc nd on ri sk-rel'Urn trade-oll. cu lr y in evaluating probabilily cli stri-
burions of \'ariablcs und tradc-()ff bc-
tween risk amI rClUm.
NPV (CAPM discolln l - - N/A Base-c¡¡se catloh flows are re<lu ired. Sta-
ntle) riSlica l data is rcqui red la estimate risk
fuclOr f3. 1t is difficult lo oblni n sl.ltis·
tic:.1 dala for sl<lnd alone projects.
NPV (A IYf discQunt mte) - - N/A Base-case cash tlows are requircd. Sta-
tisl ical dala is requi red lú eSlimate ~ , .
Thi s mcthod is designed for delemlil1 ~
ing lhe r:lIe of relum on securities.
NPV (subjecli vc di scoun l - - N/A Basc-casc cash nows arc required. Oi s-
ntte) cou m rUles are detennincd by manage-
melll subjccli vely.
V~l u e-al- ri sk - - N/A This method is dcsigned rol' dClc rmining
the rate of return on securirics. Staljs~
tieul dala is required.
APV - - N/A BU!.C-C.IM! c:v.h flows und cOlllpúnel1lS 01"
va lue are requircd. Each componen l 01'
vn luc muM ~ calc ulaled individually.
Ulility thcory - - N/A Values of uti li ty vary with dccision-mak -
ers. Vcry subjcctive.
Ri sk-rat ing sy~tems - - N/A Riltings requirc spcc ializcd leamwork .
Vel)' complicated proccss.

Note: N/A = nOl apphcable.

WA CC). The melhOO s caJc ul aling NPY al a ri sk-adjusled di s-
counL rate provide NPV with out ind icatío n of re li abi lily. T hc
decision-tree (or expeclcd return) mcthod provides lhe cx-
pecled NPY. bUI fails to I11cas ure ri sk. The other existing mClh-
ods bascd 011 pro bnbilil y analysis p ro du ce lhe cxpected NPV
from a range of possible Qulcomes. However. Ihey frti led to
provide a criIcrian t'or an accepllreject decis ion relating la risk.
T he N PV-at-ri sk mcthod produces a single N PV value fraIn ~l
range of outcomcs al a given confidence level. It lhercfore
overCO IllCS lhe prob lcl11s in Ihe o lhcr mcthods. In add ili on.
unJike r isk-raling m ethods Lhm rcq u ire a spec iali zed team la
perform, NPV-m-risk meLhod ca n be carricd out by promoters
using comme rc iall y avaiJable software.
The NPY-at-risk Illcthod is dilTcrcnl I"rol11 Ihe value- at -risk
melh od. The va luc-¡lt-ri s k is a mensure of maximum potenlial
c h a nge in va lue of a " ortfo li a or financial ins Lrllme nts w ilh a
g iven probab ility over a prese l ho ri zon (J. P. Morgan a nd R eu-
lers 1996), \.v he reas N PV-at-ri s k is lhe measurc 01' minimum
ex pected re tum fra m a project al el given co nfide nce level.
Va lue-at-risk m a inJ y I"ocuses 0 11 mark et ri sk and o tile r ri s k s
slIch as credil. Iiquidity. and cash How. w hereas the N PV-Cll-
risk mct hod takes lhe followi ng faclOrs ¡nlO aCCO UI1I : (1) A II
the poss iblc relurn s resu ltin g from IIncertainty: (2) lhe time
valu c 01" money: (3) lhe i mpael 01" financi ng metJlOds: and (4)
vario lls ri sks assoc iated w ilh BOT proj ecIs. However, bOlh of
lhe m use probabilisti c a nd statisticaJ analyses Lec hniqllcs. flnd
Monte Cari o sim ulati o n.
A majar rcq ui rernenl in usin g Lhe NPV-at-ri sk mclhod is lhe
avail abilit y a f data fa r stati stica l analysis. A llho ug h Monte
Cari o s imulmi o n o ffers a powerfu l means 10 gene rale dala.
some reasonablc sWli sti ca l distribution s of ri sk variables
sho uld be s pecifted bccause Monte Cario s imulation req uires
the di s Lribulion s af thc va riabl es. Anolher prob lem is 10 deler-
mi.ne corre Jation betwecll r is k variables in Ih e cas h fl ow

232 / JOU RNAL OF CONSTRUCTION ENGINEE RIN G A ND MANAGEMENT / MAY/JU NE 2000

mode!. As a result. lhe re liabilily of NPY-al-risk depends on
lhe simulatio n res ult s derived fram lhe specified dislributiol1s
ancl cash fl ow models. hs abil ity lO clcal wilh ri sk also dcpends
011 lhe quality of Ihe si mulation model.
CONCLUSIONS
Compared with other lypcs of capit,ll investmenls, BOT
projects are exposed lo mo re ri sks. They requ ire a mo re vig-
orous investment decision method. A sySlematic review of var-
iOU5 investment decision-making methods shows lhm WACC
and mean-vari ance methods can be combined to fonn lhe
NPV-ilt-risk Illct hod. 1I incorporales lhe time va lue of money
into lhe mean-variance method usin g NPV co ncepl and takes
financ i ng methods into aceounl using WACC as lhe discount
rate o The comparison of differen l mClhods for twO hYPolheti-
cal projects shows that this combinalion can overcom e sorne
problems inherent in olher methods, and Lhe method can be
lIsed in decision makjng fo r privately financed infrastTuclure
projecls.
JOURNAL OF CONSTRUCTION ENGINEEAING ANO MANAGEMENT I MAY/J UNE 2000/ 233
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