Economic evaluation of investment projects under uncertainty: A probability theory perspective

Abstract

In the current competitive economy, investors are constantly facing growing uncertainty when evaluating new investment projects. This uncertainty results from insufficient information, oscillating markets, unstable economic conditions, obsolescence of technology, and so on. Hence, uncertainty is inevitable in reality. In such conditions, the deterministic models, while easy to use, do not perfectly represent the real situations and might lead to misleading decisions. When the cash flows for an uncertain investment project over a number of future periods are discounted by the traditional deterministic approaches, investors may find it hard to have an accurate estimation of the project value. Therefore, this paper utilizes the probability theory tools to derive a closed-form Probability Distribution Function (PDF) and related expressions of the Net Present Worth (NPW), as a useful and frequently used criterion, for the cost-benefit evaluation of projects. The random cash flows follow normal, uniform or exponential distributions in our analysis. The PDF of the NPW is an important tool that helps investors to accurately estimate the probability of projects being economical; hence, it is an important tool for investment decision-making under uncertainty.