An integrated investment decision analysis procedure combining simulation and utility theory

Abstract

In this paper we examine several methods that management could use to cope with the problem of risk in capital investment decision – making. We use the net present value model as a measure of profitability of an investment project. This measure is discussed in relation to their applicability and interpretation in risk analysis models. It is shown that it may be worth developing an integrated decision analysis procedure. The proposed procedure includes the Monte Carlo simulation to obtain a probability distribution of net present values, the calculation of the expected net present value, risk profiles analysis by stochastic dominance criterion, and as a final step the sensitivity analysis using utility functions with different levels of risk aversion. Numerical results obtained with this procedure are given. Finally, we discuss about relatively new approach of "real options" which can be used to expand our analysis methods.