The importance of assumptions in investment evaluation

This work illustrates a new method for estimating the importance of assumptions in investment evaluation. The most diffused sensitivity analysis schemes present limitations when used to assess the importance of individual parameters and cannot be employed to estimate the importance of groups of assumptions. However, such problems can be solved by making use of the differential importance measure (DIM). We set forth the framework for the application of DIM at the parameter level of investment valuation models. We study the relationship between DIM and investment marginal behavior. We analyze the link between importance of a parameter and risk associated with it. We discuss general results for a sample valuation model. The numerical application to the valuation of an energy sector investment project follows. We rank the factors based on their importance and determine the project risk profile. We discuss the importance of groups of assumptions. Results will show that assumptions relating to revenues are the most influential ones, followed by discounting and operating cost assumptions. We discuss numerically the relationship between importance and risk, analyzing the effect of variable costs hedging through the comparison of the project risk profile in the presence and in the absence of such a hedging. (c) 2005 Elsevier B.V. All rights reserved.