4.3 Using probability and future cash flows to deal with risk

One way to deal with risk is by using estimated cash flows in NPV analysis that take into account the range of outcomes that could occur in the future. In fact, this has already been done implicitly when talking about cash flows in earlier sections: it is rare that the values of future cash flows that will occur are known precisely.

Estimated cash flows using the probability of different values of the cash flows allows NPV analysis to take into account the possibility that actual cash flows are better or worse than expected. This also allows adjustment for when there is a chance that cash flows may not occur at all (i.e. they may have zero value). An extension of this technique is to assign probabilities to different possible future scenarios and calculate the expected NPV for each scenario. The probability of each scenario can then be used to calculate an overall probability-weighted NPV. This probability-weighted NPV is used to decide whether the project should go ahead.