Civil Engineering Reference
In-Depth Information
This chapter provided the first step to manage the associated risks of NZER
given a life cycle perspective of these uncertainties. Identification of these risks
occurs by looking at the limited historical data of NZER. Not only is the nature of
the NZER risks important, but also proper consideration must be given to all the
associated uncertainties. The stakeholder should have at his disposal ample and
adequate resources to ensure that the refurbishment objectives are completed even
in the most difficult circumstances. Furthermore, uncertainties affect the evaluation
of NZER, and thus, we need to have a way to account for them. A method other
than the traditional NPV approach is required to accommodate the uncertainties in
the investment decision of NZER. Because of this, an approach to project eval-
uation based on the option pricing theory was proposed by Menassa (
2011
)to
account for these uncertainties in existing building investments. This approach is
summarized in the next section along with a case study example to illustrate its
applicability.
5 NZER Evaluation Under Uncertainty
Different approaches to project evaluation other than traditional quantitative
capital budgeting techniques like pay-back period, IRR, and NPV are required to
accommodate the uncertainties in the investment decision of NZER. Among these
methods, NPV is the only technique that ensures the stakeholder objectives of
maximizing return on investment (Copland and Tufano
2004
; Trigeorgis
1996
).
However, the NPV method alone has several limitations. For example, it requires a
discount rate, which cannot be easily determined and is often the decision-maker's
choice to establish this rate (Rushing and Lippiatt
2009
; Dell'lsola and Kirk
2003
;
and Fuller and Petersen
1995
). The discount rate has two components: the risk-free
component and the risk premium. The risk-free component is usually set by the
lender and can be easily determined. The risk premium, in this particular case, will
account for the uncertainties associated with NZER expected costs and returns.
The value of the risk premium affects the final discount rate used to perform the
NPV analysis (Ye and Tiong
2000
; Dowd
1998
). In addition, the NPV assumes
that all future cash flows for a given investment are known in advance (Copland
and Tufano
2004
; Luehrman
1998
). This is considered a limitation when
performing an investment evaluation for NZER when it is impossible to predict
accurately the future benefits and costs given the uncertainties discussed in the
previous section.
Thus, from an investor perspective, a highly risky and unacceptable investment
can be easily adjusted to look favorable with a positive NPV by just changing the
risk premium component of the discount rate. Similarly, an investment with a
negative NPV could also be simply adjusted to look less unfavorable by just
changing the risk premium component of the discount rate. Another way to adjust
the NPV results is to use the NPV-at-risk method where the primary variables
underlying a project's NPV are simulated to obtain distribution and confidence
