Guide to COST-BENEFIT ANALYSIS of investment projects - Ramiri

Figure 2.6 Probability distribution for NPV0.160.14Probablity distribution0.120.10.080.060.040.020-10 -5 -4 -2 0 2 4 8 12 15 18 20NPVThe cumulative probability curve (or a table of values) permits an assessement of the project risk, forexample by verifying whether the cumulative probability is higher or lower than a reference value that isconsidered to be critical. One can also assess the probability that the NPV (or FRR) will be lower than acertain value, which is adopted as the benchmark (e.g. zero for NPV and 5% for FRR). In the example,see Figure 2.7, there is a probability of about 30% that the NPV will be negative.Figure 2.7 Cumulative probability distribution for NPV120%Cumulative Probability100%80%60%40%20%0%-10 -5 -4 -2 0 2 4 8 12 15 18 20NPV2.6.4 Assessment of acceptable levels of riskOften the NPVs and IRRs reported in project appraisal reports refer to best or baseline estimates, perhapsmeaning ‘most likely’ values (or mode). However, the criterion for project acceptability should be that ofthe expected value (or mean) of such indicators, calculated from the underlying probability distributions.For instance, if a project has an ERR of 10% but also the probability risk analysis tells us that the ERR hasa value between 4 and 10 with a probability of 70% and a value between 10 and 13 with a probability of30%, then the expected value of ERR for that project is only 8.35% [average(4,10)*0.7 +average(10,13)*0.3].In conclusion, the procedure described allows for the selection of projects not only on the basis of thebest estimate, but also based on the risk associated with it, simply by weighting the performance with therisk. In principle, the expected performance, and not the modal one, is the value that should be reportedin the application form for major projects requiring EU assistance. In order to evaluate the result, one62