MEASURING RISK IN INVESTMENT PROJECTS: NPV AT RISK Harvard Case Solution & Analysis

Problem Diagnosis
This case relates to the discussion and illustration of value at risk and net present value at risk techniques for making the strategic capital investment decisions. Most of the companies usually make use of the net present value and the internal rate of return metrics to compare two or more investments and decisions of investment between the mutually exclusive projects based on net present value, profitability index and the payback period of the investments.
However, since the estimation of the cash flows and the discounting of the cash flows to arrive at the net present value is based on substantial uncertainty in the real applications and companies fail to manage these uncertainties. Companies lack the appropriate tools to manage these uncertainties. In this report, we highlight the importance of accounting of such uncertainties through value at risk and net present value at risk and we also examine the power plant example provided in the case to illustrate the concept of NPVAR further.
MEASURING RISK IN INVESTMENT PROJECTS NPV AT RISK Harvard Case Solution & Analysis

Case Analysis
We first begin our analysis by defining what is value at risk and net present value at risk.
Description of VAR and NPVAR
Value at risk is basically the measure of the risk of the investments and this metric measures the amount or the percentage of the value of an investment that might be lost, given the normal market conditions. This is typically used by the regulators and the firms to gauge the different assets that are required by the firms to cover the potential and possible losses that might occur(Wilmott, 2007).
Financial institutions typically calculate their short-term VARs by bootstrapping the range of volatility in similar historical periods, or by parametrizing assumed probability distributions of financial-asset prices. These complex techniques are not needed in most business applications and they can be replaced by Monte Carlo simulations, complemented with the insights provided by senior management about key strategic uncertainties of the business(Wilmott, 2007).
On the other hand, net present value at risk could also be defined in a similar manner. NPVAR is defined as the range of the values of the net present value that could be taken by an investment based on the uncertain risks that are considered by the management of the companies. NPVAR is normally measured as the gap between the baseline net present value and the fifth percentile of the net present value distribution(Philippe, 2006).
The main advantage of net present value at risk is that it measures the risk in monetary units and even dollars however, the downside of the investment can also be calculated in terms of percentage value at risk. This is what we have illustrated for the power plant example that is illustrated in this case. There are a range of different industries where net present value at risk has been adopted such as oil and gas companies, global retailers and several airlines.....................

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