Introduction

Financial modeling is among the most significant tools in investment decision-making, especially in a volatile economic environment. Modern industrial enterprise is subject to high uncertainty associated with market volatility, regulatory changes and technological advancement. In these conditions, it is necessary to apply proven techniques of analysis and forecasting, which allow not only to assess investment prospects, but also to minimize financial risks. Financial models, such as Net Present Value (NPV), Internal Rate of Return (IRR), and scenario analysis, enhance the objectivity of investment project appraisal and contribute to a more balanced approach to strategic capital management.

Despite their widespread use, these models are primarily applied in the industrial sector under specific conditions, including high capital intensity, extended payback periods, and the necessity for substantial upfront investments. One should learn which methods of financial modeling have the highest forecasting ability and provide the most accurate assessment of investment profitability.

The aim of this study is to explore theoretical foundations and methodology of financial modeling of investment projects in business. The paper concentrates on exploring efficacy of NPV, IRR and scenario analysis methods, ascertaining their merits and demerits for use in strategic management of investments.

Main part. Financial modeling as a tool for investment analysis

Financial modeling is the method of creating numerical models that reflect the financial position of a firm or project and can predict its future. This instrument allows managers and analysts to make logical choices based on quantitative data, which is especially important for industrial corporations where investment initiatives can entail significant monetary expenses. The main objective of financial modeling is to find out the profitability of investment projects, evaluate financial flows, and minimize risks of capital investment [1].

There are several financial modeling techniques that have extensive use in investment appraisal. Among the most widely used is the NPV technique, which allows you to discount cash flows to their current value, all the way back to the start of the project, taking into account the time value of money. The method assists in determining if an investment project will be profitable according to its long-term profitability [2]. At the same time, another fundamental contribution to the NPV method is the IRR, which determines the interest rate at which the NPV of the project is equal to zero. IRR is a suitable tool to employ when comparing more than one project, especially when they have similar cash flows and different amounts of capital.

One of the greatest advantages of financial modeling is the ability to use scenario analysis, where it is possible to factor in uncertainties of the future. It involves modeling several potential scenarios for the direction of events, for instance, optimistic, pessimistic, and most likely. Scenario analysis helps investors and managers to understand how the change in key factors, say market prices, raw material prices, or changes in tax laws, can affect the profitability of a project. In the industrial sector, where changes can be extreme, this method is very helpful [3].

Thus, financial modeling is not simply a set of mathematical instruments, but an important part of strategic planning at any phase of the life cycle of the investment project. It is an instrument that not only serves to identify present-day risks, but to make forecasts which will help select the most promising development paths for the company. Effective utilization of such models assumes deep experience and expertise, since a wrong estimate can cause huge economic losses. Hence, analysis methods must be constantly refined and used in accordance with the characteristics of specific industries and project types.

Review of key methods for evaluating investment projects

The effectiveness of investment decisions is determined based on quantitative analysis, which allows assessing the potential profitability of a project taking into account the time value of money, risks and capital expenditures. As mentioned earlier, in modern financial analysis practice, several key methods are used to systematically assess the attractiveness of investments. Among them, the most widely used are the NPV method, IRR and scenario analysis. Each of these tools has its own advantages and limitations, which determines their applicability depending on the characteristics of a specific project and industry (table 1).

Table 1

Comparison of key investment project evaluation methods

The NPV method is considered the best method for measuring investment projects. The technique depends on discounting the future cash flow using a coefficient of the cost of capital. The basis law of NPV is that the project will be economically acceptable when its value proves to be positive. For example, if investments into an industrial company are 100 million USD, and discounted cash flows over 10 years yield a NPV of 20 million USD, this will indicate its profitability. However, while extremely widely used, this method is not perfect: choice of a discount rate renders the result of the calculation very sensitive to it, and future cash flows can be associated with high uncertainty [4].

The IRR method is a figure that measures the level of profitability of a project at which NPV would be zero. It is a convenient method to utilize when comparing multiple projects since it does not require choosing a discount rate, yet it shows return on investment in percentage form. For example, if IRR is 15% and the company’s cost of capital is 10%, then the project can be regarded as profitable. However, IRR might give inconclusive results in circumstances where investment projects contain non-traditional cash flows with sign change (i.e., replacement of profits with losses and vice versa in different periods). Under such circumstances, several IRR values can be obtained, thus making it complicated to interpret the results [5].

An additional analysis tool is scenario modeling, which allows for various development options to be taken into account. Unlike NPV and IRR, which are calculated based on fixed assumptions, scenario analysis involves modeling several possible project development options. For example, three scenarios can be modeled for industrial enterprises:

• Optimistic, which implies an increase in demand and a decrease in costs.
• Base, reflecting current market conditions.
• Pessimistic, taking into account possible crises, inflation or rising interest rates.

In general, scenario analysis allows us to consider several possible scenarios, which makes it possible to assess possible risks and determine the best way to implement an investment project. This approach helps to adapt strategic decisions in the face of uncertainty and changing external factors, ensuring more informed investment decisions (fig. 1).

Figure 1. The principle of constructing scenario analysis [6]

Scenario analysis allows you to find out the sensitivity of an investment project to changes in the most significant parameters. For example, if under unfavorable conditions the profitability of the project reduces considerably, this can be an indicator of high risks and the need to change the investment strategy.

Thus, the choice of the evaluating method of an investment project will depend on various factors: the structure of the cash flow, risk level, planning horizon and industry characteristics. The combination of NPV, IRR and scenario analysis approaches allows us to obtain a more objective and detailed image, especially required for the industrial enterprises characterized by high capital costs and extensive project implementation durations.

Risks and uncertainties in the evaluation of investment projects

Project appraisal of investment is always associated with some level of risk and uncertainty, and the accuracy of forecasting cash flows is particularly challenging. In particular, industrial companies, which have the potential to involve high capital expenditures and lengthy time horizons, can be exposed to a large number of influences that can significantly affect the result of the appraisal. One of the most potent sources of uncertainty is economic volatility, which may lead to a change in market conditions, resource costs, or labor costs.

Uncertainty in estimating cash flows and the cost of capital requires a specific approach to the choice of discount rate in the NPV model. An error in the estimation of this rate can lead to considerable distortions in the evaluation of the project. For example, with the fluctuation of the market interest rate by 2-3%, the NPV will change by 10-15%, which is of utmost importance for long-term investments. Among the risk factors is regulatory changes, i.e., tax policy changes, environmental regulations or legislative proposals [7]. For industrial firms subject to strict government regulation, such changes can significantly impact financial results, which must be taken into account.

Scenario analysis somewhat reduces the impact of uncertainty by modeling various possibilities for future conditions. Even with the use of this tool, however, it is important to understand that the validity of projections is highly dependent on the quality of the input data and how accurate the choice of assumed scenarios is. Inability to make accurate predictions of market trends, volatility in commodity prices or unexpected political risks can negatively affect investment decisions. It is here that the choice of the right assessment method and the ability to adapt it to changing situations prove to be instrumental for successful investment management.

Methodological aspects of the application of NPV, IRR models and scenario analysis

The application of NPV, IRR and scenario analysis techniques in investment analysis needs a special technique that considers the project specifics and risks. Each of these techniques has its own calculation specifics and needs a cautious approach when interpreting the results. It is necessary to know how to apply these models properly and how to properly consider external factors influencing the accuracy of the forecast [8].

The NPV technique is most commonly applied technique for analyzing investment projects. However, its effectiveness relies solely on the correct choice of the discount rate. It’s often determined according to the cost of capital of the firm, but in fact, its choice can greatly affect the results. For industrial firms whose projects can span decades, an error in calculating the discount rate can produce extreme variations when it comes to determining the profitability of the project. As an example, if the discount rate is too high, the NPV might be negative even if the project is ultimately profitable. Therefore, while applying the NPV method, while doing the rate calculation with care, one needs to take into account changes in the macroeconomic environment, such as changes in inflation, interest rates, and cost of capital.

Special consideration also needs to be given to IRR. While using this technique, one should keep in mind that IRR might not offer a unique solution if the project has multiple cash flows. For instance, when implementing the project, there could be positive as well as negative cash flows across various periods, and then at some point a situation could arise where multiple values of IRR are obtained, which makes the decision-making complex. In such cases, the use of the NPV method or other analysis to shed light on the findings is recommended.

Scenario analysis is very important in businesses or sectors in which the external environment can rapidly alter within a few seconds. It involves analysts creating multiple plausible development scenarios, e.g., optimistic, baseline, and pessimistic. In addition, while creating scenarios, the impact of risk factors such as legislative reforms, market price volatility, or environmental hazards should be considered. Scenario analysis not only assists in predicting possible outcomes, but also prepares one for uncertainty that is bound to arise in the event of long-term investments.

Thus, the effective application of NPV, IRR models and scenario analysis does not just depend on mathematical operations, but also on deep understanding of the specifics and background of the investment project. It is necessary to take into account the external risks, to make a correct selection of parameters for modeling and use other analysis methods to get more reliable and substantiated results.

Conclusion

Financial modeling is an important way of estimating investment projects in business. NPV, IRR methods and scenario analysis allow not only to analyze the profitability of projects, but also to account for risks associated with uncertainty in the external environment. Despite wide usage, all of these methods are subject to certain limitations that must be taken into consideration when making investments. The most significant problem is choosing the appropriate parameters for calculation, for instance, discounting rate or scenarios of possible variations in external conditions. In total, the combined use of these models gives a more accurate picture for strategic decision-making, and this makes it easier to implement long-term investment projects in an uncertain economic climate.