Significance and Use
Investments in long-lived projects such as buildings are characterized by uncertainties regarding project life, operation and maintenance costs, revenues, and other factors that affect project economics. Since future values of these variable factors are generally not known, it is difficult to make reliable economic evaluations.
The traditional approach to project investment analysis has been to apply economic methods of project evaluation to best-guess estimates of project input variables as if they were certain estimates and then to present results in single-value, deterministic terms. When projects are evaluated without regard to uncertainty of inputs to the analysis, decision makers may have insufficient information to measure and evaluate the risk of investing in a project having a different outcome from what is expected.
Risk analysis is the body of theory and practice that has evolved to help decision makers assess their risk exposures and risk attitudes so that the investment that is the best bet for them can be selected.
Note 1—The decision maker is the individual or group of individuals responsible for the investment decision. For example, the decision maker may be the chief executive officer or the board of directors.
Uncertainty and risk are defined as follows. Uncertainty (or certainty) refers to a state of knowledge about the variable inputs to an economic analysis. If the decision maker is unsure of input values, there is uncertainty. If the decision maker is sure, there is certainty. Risk refers either to risk exposure or risk attitude.
Risk exposure is the probability of investing in a project that will have a less favorable economic outcome than what is desired (the target) or is expected.
Risk attitude, also called risk preference, is the willingness of a decision maker to take a chance or gamble on an investment of uncertain outcome. The implications of decision makers having different risk attitudes is that a given investment of known risk exposure might be economically acceptable to an investor who is not particularly risk averse, but totally unacceptable to another investor who is very risk averse.
Note 2—For completeness, this guide covers both risk averse and risk taking attitudes. Most investors, however, are likely to be risk averse. The principles described herein apply both to the typical case where investors have different degrees of risk aversion and to the atypical case where some investors are risk taking while others are risk averse.
No single technique can be labeled the best technique in every situation for treating uncertainty, risk, or both. What is best depends on the following: availability of data, availability of resources (time, money, expertise), computational aids (for example, computer services), user understanding, ability to measure risk exposure and risk attitude, risk attitude of decision makers, level of risk exposure of the project, and size of the investment relative to the institution's portfolio.
Scope
1.1 This guide covers techniques for treating uncertainty in input values to an economic analysis of a building investment project. It also recommends techniques for evaluating the risk that a project will have a less favorable economic outcome than what is desired or expected.
1.2 The techniques include breakeven analysis, sensitivity analysis, risk-adjusted discounting, the mean-variance criterion and coefficient of variation, decision analysis, simulation, and stochastic dominance.
1.3 The techniques can be used with economic methods that measure economic performance, such as life-cycle cost analysis, net benefits, the benefit-to-cost ratio, internal rate of return, and payback.
