Monte carlo simulation in valuation of investment projects

Abstract

Valuation of investment projects is a crucial part of the investment decision making process. The most important part of any investment analysis are discounted cash flow methods: net present value (NPV) and internal rate of return (IRR). The aim of this paper is application of risk analysis technique - Monte Carlo simulation, including sensitivity and scenario analysis, in investment project valuation. For this purpose, we have used an investment project - the new plant for the combined production of electrical and thermal energy, as a case study. The input (key) variables used in this analysis, for performing a Monte Carlo simulation, are total revenue, variable costs, initial investment and discount rate, determined by the sensitivity analysis. As the output variables we have used net present value (NPV) and internal rate of return (IRR). Monte Carlo simulation results show that the probability of the project's success is 86.1%, according to the NPV rule, and 91.9%, according to the IRR rule of project's acceptance.