Economic Risk Analysis Using Analytical and Monte Carlo Techniques
Investment decisions are typically based on some form of cash-flow analysis, such as net present value (NPV) or internal rate of return (IRR). The analysis is first performed using predicted performance of the project over the project life as if the predictions were deterministic. The stochastic nature of these predictions can then be handled using a variety of risk analysis techniques, such as: best case/worst case scenarios; single-parameter sensitivity analysis (Strauss plots); analytical error propagation; Monte Carlo simulation; and decision trees. In this paper, we present the development and application of a Microsoft Excel spreadsheet template that facilitates analytical and Monte Carlo risk analysis of investment decisions. We have found the template particularly useful in teaching risk analysis to senior students in the design course.