Analyzing Uncertainty Inherent in New Projects

Money + Time = Uncertain Results
To evaluate the uncertainty of adding a project to the firm’s portfolio, project managers conduct risk analysis activities such as simulation. Crystal Ball is a tool for conducting simulations quickly and with an appropriate level of frequency. Since comparable information is most useful when evaluating various investment options but many projects perform over varying durations, financial information used to quantify the return should incorporate the time value of money. Net present value is the most qualified measure.

To begin analyzing a project, inflows and outflows should be estimated for each period of performance. For multi-year projects, the standard practice is to set the investment as an outflow in the period prior to execution. Next, analysts collect performance period cash inflows and outflows as unadjusted values. Subtracting outflows from inflows yields net flow for each period. Applying a discount factor normalizes the estimates to present dollar values. To begin the Crystal Ball simulation, assign the net flows as assumptions with a reasonable distribution model. Do the same for potentially uncertain values that affect the discount rate (e.g. inflation). Next, set the Net Present Value calculation as the forecast variable. Finally, run the simulation to determine the NPV means and standard deviations.

Other tools to determine uncertainty of projects include qualitative risk analytic tools and quantitative risk analytic tools. Qualitative tools present relative representations of uncertainty. Examples include the risk probability and the impact matrix. Quantitative tools include simulations, such as Crystal Ball, and expected monetary value analysis.

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