Forecasts of Prices and Informed Sensitivity Analysis: Applications in Project Valuations

Abstract

From corporate budgeting to public planning, we hear that commodity prices are uncertain and that, when they vary, key investment measures sway with them. However, claiming that commodity prices are outside a firm’s domain of control, corporate decision makers tend to disregard this uncertainty or at best reflect it in naïve sensitivity analyses. Yet, firms should take in the understanding about key uncertain factors to avoid inferior decisions and loss of value. In this paper, we show that the customary practice of analysis with arbitrary “high” and “low” forecasts of prices is inconsistent with the general understanding about commodity price dynamics and the financial theory. To alleviate this, we develop consistent and project-specific forecast of prices that support valuations and decision making.