Financial factor models for correlated inputs in the simulation of project cash flows

In this paper we discuss a coherent and consistent framework for valuation of large-scale projects—the risk-neutral valuation scheme. This valuation framework deals with the uncertainties at the source instead of risk-adjusting the discounted cash flows. The uncertainties are categorized into two groups; market (public) uncertainties and technical (private) uncertainties. Some of the uncertainties are dependent on each other and ignoring such inter-dependencies will affect the valuation results. However, for problems with a large number of sources of uncertainties, the assessment of inter-dependencies becomes complex and burdensome. In this paper, we introduce financial factor models to simplify the correlation assessment problem. The factor models can be integrated with the logic of risk-neutral valuation and will form a consistent approach to valuation.