Risk Analysis in Project Appraisal: The assessment of risk and return in capital investment decisions

There are four key areas in a capital investment evaluation that make for a good and sound appraisal of risk and return. The methodology of cost benefit analysis for capital investment projects is of course a prerequisite for a sound appraisal. There is general consensus regarding the practice and application of cost benefit analysis in the appraisal of capital investment projects and in determining economic viability. Although the correct methodology is necessary, it is not always sufficient to facilitate the decision of whether to invest.For a sound investment appraisal, one further needs to use a sound and robust integrated financial model which correctly and prudently applies the methodology of Cost-Benefit Analysis. Secondly, it is also fundamental to structure the projection parts of such a model only after first doing the serious homework on the market and competitive analysis data to be projected in the appraisal. This phase which unfortunately is not given enough attention in practice is essential to reveal the driving parameters and to be projecting growth patterns for key variables in a consistent and coherent manner. A good and thoughtful marketing analysis is also key when subjecting the financial projections to risk analysis using Monte Carlo Simulation. Last but not least, the above analysis should lead to the derivation of the project’s risk profile and how it may impact the various stakeholders and financiers of the project. This facilitates an appropriate agreement for a financing structure and for sharing of the risks among all stakeholders. Each of these aspects of investment appraisal are addressed in this manuscript.