Professional Documents
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217±222, 1999
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This paper treats investment decision-making under uncertainty and risk. Some of the methods
used for investment decision-making under uncertainty and risk are presented: Break-even
Analysis, Sensitivity Analysis, Theory of Games and Decision Making Theory. Sensitivity
Analysis is given special consideration, and one of the procedures of its application in investment
decision making under uncertainty and risk is shown. # 1999 Elsevier Science Ltd and IPMA.
All rights reserved
Keywords: sensitivity analysis, investment project evaluation
can be expressed as the critical point of production several dierent values of criteria for each investment
(critical use of production capacity), or as the critical alternative, and where we do not know which alterna-
sale income (critical sale price per unit). Break-even tive will be realized in practice. Investment decision-
Analysis is a static approach to investment project making in cases of risk is the decision-making where
evaluation in cases of uncertainty, because it uses data we predict several dierent values of criteria for each
on only one representative year of the project life alternative, but with the known probability of their
cycle. occurrence. Investment decision-making in cases of
Application of the Break-even Analysis in invest- certainty is the decision-making where each alternative
ment project evaluation in cases of uncertainty is always gives one and the same criterion value, i.e.,
based on the idea of the critical values of certain par- where we are able to predict all necessary future values
ameters which exert a great in¯uence on the total prof- absolutely correctly.
itability of the project. In other words, this means A rather large number of criteria and methods are
calculation and analysis of the critical or the minimum applied by the Theory of Games and Decision Making
values of the production scope and income from sale Theory used for a solution to the problems of invest-
below which the project becomes unacceptable, as well ment decision-making under conditions of uncertainty.
as taking steps to avoid such. Break-even Analysis is a Among the best known are: Minimax Criterion,
very simple method, with lots of weaknesses. It should Maximax Criterion, Hurwicz's Criterion, Laplace's
therefore be used only for the initial analysis in invest- Criterion, Savage's Criterion, etc.
ment project evaluation in cases of uncertainty.3
For investment decision-making in cases of uncer-
tainty, and for mathematical modelling of the decision
making principles, the Theory of Games and Decision
Making Theory are also used. The Theory of Games
provides mathematical models of con¯ict situations, Sensitivity analysis
and with the assistance of certain principles provides Investment project evaluation, and research of criteria
solutions of such situations. In order to solve a man- which make the basis of this evaluation are performed
agement-related problem, and of course a problem of through an agency of certain input values serving for
evaluation and choice of investments using the Theory calculation of individual criteria. Due to the eect of
of Games, it is necessary to deploy it in its matrix dierent factors it is potentially possible that these
form. Matrix games used for solution of con¯icts and input values are not realized in the future, which
uncertain situations can be: games against the makes our ®nal evaluation scores incorrect. If we want
Intelligent Opponent, and the games against the to take into consideration all possible consequences,
Nature.2 we have to analyse, in advance, the eect of potential
In a game against an Intelligent Opponent, we sup- changes of the starting values on the ®nal factual state
pose that the adversary will behave in an intelligent or results obtained by the calculation with these
and rational manner, and that he/she will choose the values, which is performed through procedures of the
best possible strategy to maximize his/her potential Sensitivity Analysis.
income or minimize his/her potential loss. We thus try Sensitivity Analysis is the calculating procedure used
to predict the opponent's strategy and to create our for prediction of eect of changes of input data on
own, using such predictions. That makes the choice in output results of one model. This procedure is often
such games adjusted to the opponent. used in investment decision making related with the
In the games against Nature, our opponent is investment project evaluation under conditions of
Nature, so we cannot be certain about any rational uncertainty.4
behaviour. In such situations we take that behaviour Sensitivity Analysis of the eectiveness criterion for
to be uncertain. While a game against the Intelligent investment project evaluation is the calculating pro-
Opponent makes our choice determined by predicting cedure of researching and determining the eect of
possible behaviour of the adversary, in a game against changes of individual values taken into the calculation
Nature we presume that no reliable information about on the values of individual criteria, as well as on the
possible behaviour is provided, and therefore our ®nal investment project evaluation. In other words, it
choice is free. is a procedure that analyses how the changes of certain
Solution of investment problems, i.e. investment de- input values (income, costs, value of investments, etc.),
cision-making, belongs to the category of games produced due to inappropriate prediction or for some
against Nature. The diering and varying future con- other reason, in¯uence certain criteria values and the
ditions which should be predicted, and which are total investment project evaluation. Applying this
shown through several varying size values relevant for analysis it is possible to ®nd the maximum or mini-
a choice can be more or less known, and thus the mum points which one value may take while, however,
degree of their uncertainty can be higher or lower.2 still allowing an investment project to be justi®ed and
The usual classi®cation used in investment decision- acceptable for realization.
making comprises dierent degrees of knowledge In the investment project evaluation we have at our
about the future: disposal a set of criteria (Net Present Value, Internal
Rate of Return, Pay-back Period, etc.) as the basis for
. uncertainty
evaluation (set of output values), and the set of values
. risk
(income, costs, discount rate, value of investments,
. certainty
etc.) on the basis of which we can calculate certain in-
Investment decision-making under conditions of dividual criteria (input values), as shown by the dia-
uncertainty is the decision-making where we predict gram in Figure 1.5
218
Sensitivity analysis in investment project: P JovanovicÂ
cing NPV>0 are acceptable. In Table 2 there are two Value criterion dependence on the discount rate is
separate zones, bordered o by the dotted line. The given in Figure 2.
zone situated below the line yields unacceptable
results, while the zone above the line oers acceptable
results. This means that with 20% for the discount
rate, and 26% for increase of the total value of invest- Conclusion
ment, we have NPV < 0, and our investment project This paper studies the investment project evaluation
is unacceptable. At the same time, for the starting and the decision-making problems under the con-
total value of investment, with the discount rate of up ditions of uncertainty. Evaluation of investment pro-
to 28.2% the Net Present Value criterion is negative. jects under uncertainty and risk is possible to be
The discount rate (28.2%) is the value of the Internal carried out through application of various methods
Rate of Return criterion. The graph of the Net Present and techniques. The best known methods are: Break-
221
Sensitivity analysis in investment project: P JovanovicÂ
even Analysis, Sensitivity Analysis, Scenario Method, 6. Ray, A., Cost-Bene®t Analysis, The Johns Hopkins University
Theory of Games and Decision Making Theory, etc. Press, Baltimore, 1987.
Sensitivity Analysis of criteria for investment project
evaluation is a very complex procedure. Applications
Petar M. Jovanovic is a professor
of the Sensitivity Analysis by using the Net Present on Project Management at the
Value, Internal Rate of Return, and Pay-back Period Faculty of Organizational Sciences,
criteria have been presented. With the Sensitivity University of Belgrade. Graduated
Analysis we are able to obtain a great deal of infor- on Faculty of Mechanical
mation about the eect of input parameters on the Engineering, University of Belgrade,
he holds a Master's degree and
examined criteria for investment project decision mak- Doctor's degree in management
ing. We can also collect information about the in¯u- from the University of Belgrade. He
ence of input parameters on the criteria values and worked in several companies, and
thus improve investment decision-making. since 1978 has been employed as
a professor on Faculty of
Organizational Sciences, University
of Belgrade. From 1991±1996 Petar
References was a dean of a faculty. Now he is
1. Squire, L. and Tak, H.G., Economic Analysis of Project, J. a professor at the Faculty of
Hopkins, Baltimore, 1979. Organizational Sciences on Project Management and Investment
2. Jovanovic, P., Investment Management, Faculty of Project Evaluation. He is the author of 20 books in the ®elds of
Organizational Sciences, Belgrade, 1991. management, project management and organization, and has writ-
3. Manual for Evaluation of Industrial Projects, UNIDO, 1979. ten many papers. He has acted as a consultant for several compa-
4. Adler, H.A., Economic Appraisal of Transport Projects, The nies and has managed several investment projects. He is a
Johns Hopkins University Press, Baltimore, 1987. President of Yugoslav Project Management Association
5. Stone, R., Management of Engineering Projects, Macmillan (YUPMA), and editor-in-chief of the International journal in
Education, London, 1988. Management.
222