DRA/K V

Decision and Risk Analysis

Financial Modelling & Risk Analysis
Kiriakos Vlahos Spring 2000

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Session overview

Why do we need risk analysis?

Project evaluation
Risk analysis approaches Scenario analysis

Sensitivity analysis
Monte-Carlo simulation Summary

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Risk management in business

Corporate risk Capital budgeting and portfolio evaluation

Project Evaluation

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Why do we need risk analysis?

Single point forecasts are dangerous!

Derive bounds for the range of possible outcomes

Sensitivity testing of the assumptions Better perception of risks and their interaction Anticipation and contingency planning Overall reduction of risk exposure through hedging

Risk analysis helps you develop insights, knowledge and confidence for better decision making and risk management.

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Risk analysis approaches

Scenario analysis

Sensitivity analysis
Monte-Carlo simulation Decision Analysis Option theory

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Skywalker

Proposal to open and operate a video store. You can expect to make at least 50,000 in the first year

Assumptions Monthly Purchase (no of tapes) Tape Price Tape Life (no of plays) Plays per Mth (per tape) Rent per Day Shop Rent p a Interest p a

50 30 30 4.33 3 6,000 10%

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Project Evaluation

Evaluating a business proposition

Does it make sense overall?

Market conditions Trust issues

What is the outlook under a basic

set of assumptions? (Base Case) What are the risks involved?

Writing a business plan

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Base case model

SKYWALKER VIDEO MODEL in 000 Jan Feb Average Stock 1.0 1.1 Opening Cash Rental recpts Purchases Replacements Rent qtrly Total Interest Closing Cash 3.0 10.8 -30.0 -4.3 -1.5 -22.0 -.2 -22.2 -22.2 11.4 -1.5 -4.5

Mar 1.1 -17.0 11.9 -1.5 -4.8

Apr 1.2 -11.5 12.4 -1.5 -5.0 -1.5 -7.0 -.1 -7.0

May 1.2 -7.0 13.0 -1.5 -5.2

Jun 1.3 -.8 13.5 -1.5 -5.4

Jul 1.3 5.9 14.1 -1.5 -5.6 -1.5 11.4 .1 11.4

Aug 1.4 11.4 14.6 -1.5 -5.8

Sep 1.4 18.9 15.2 -1.5 -6.1

Oct 1.5 26.7 15.7 -1.5 -6.3 -1.5 33.1 .3 33.4

Nov 1.5 33.4 16.2 -1.5 -6.5

Dec 1.6 42.0 16.8 -1.5 -6.7

-16.9 -.1 -17.0

-11.4 -.1 -11.5

-.8 .0 -.8

5.9 .0 5.9

18.7 .2 18.9

26.5 .2 26.7

41.6 .3 42.0

50.5 .4 51.0

SKYWALKER VIDEO Monthly closing cash for base scenario

60.0 50.0 40.0 30.0 20.0 10.0 .0 -10.0 -20.0 -30.0 Jan Feb Mar Apr May Jun Jul Aug Sep Oct Nov Dec

Closing cash exceeds 50000 at the end of the year

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Scenario analysis

Scenarios are discrete internally consistent views of how the world will look in the future, which can be selected to bound the possible range of outcomes that might occur.
Michael Porter in Competitive Strategy

Shell flavour of scenarios Scenarios should present testing conditions for the business. The future will of course be different from all of these views/scenarios, but if the company is prepared to cope with any of them, it will be able to cope with the real world.

Do not assign probabilities to scenarios!

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Skywalker Scenarios analysis

Optimistic
60 25 35 5.00 3.00 3,000 15

Assumptions Monthly Purchase Tape Price Tape Life Plays per Mth Rent per Day Shop Rent p a Interest p a

Base
50 30 30 4.33 2.50 6,000 10

Pessimistic
40 35 25 2.50 2.00 10,000 7

190,000

140,000

Skywalker Final Cash: Comparison of Scenarios

90,000

40,000

-10,000 Jan

Feb

Mar

Apr

May

Jun

Jul

Aug

Sep

Oct

Nov

Dec

-60,000 Optimistic Base Pessimistic

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Sensitivity analysis

Explore robustness of results to variations in model parameters Understand and challenge assumptions Methodology Identify variables to which results are particularly sensitive and those to which they are relatively insensitive Gain an indication into range over which results might vary, thus assessing the risks Tools What-if questions One-way sensitivity analysis Two-way sensitivity analysis Tornado diagrams Spider plots

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What-if analysis

What-if Tape Price turns out to be 35?

Assumptions Monthly Purchase 50 Tape Price 35 Tape Life 30 Plays per Mth 4.33 Rent per Day 2.50 Shop Rent p a 6,000 Interest p a 10 SKYWALKER VIDEO MODEL in 000 Jan Feb Average Stock 1.0 1.1 Opening Cash Rental recpts Purchases Replacements Rent qtrly Total Interest Closing Cash 3.0 10.8 -35.0 -5.1 -1.5 -27.7 -.2 -28.0 -28.0 11.4 -1.8 -5.3 Results Panel: Final Cash 30,926

Mar 1.1 -23.8 11.9 -1.8 -5.6

Apr 1.2 -19.4 12.4 -1.8 -5.8 -1.5 -16.0 -.1 -16.1

May 1.2 -16.1 13.0 -1.8 -6.1

Jun 1.3 -11.1 13.5 -1.8 -6.3

Jul 1.3 -5.6 14.1 -1.8 -6.6 -1.5 -1.4 .0 -1.4

Aug 1.4 -1.4 14.6 -1.8 -6.8

Sep 1.4 4.7 15.2 -1.8 -7.1

Oct 1.5 11.1 15.7 -1.8 -7.3 -1.5 16.2 .1 16.4

Nov 1.5 16.4 16.2 -1.8 -7.6

Dec 1.6 23.5 16.8 -1.8 -7.8

-23.6 -.2 -23.8

-19.2 -.2 -19.4

-11.0 -.1 -11.1

-5.6 .0 -5.6

4.6 .0 4.7

11.0 .1 11.1

23.3 .2 23.5

30.7 .3 30.9

Changing Tape Price to 35, and leaving all other planning values at their base value, we get a December Closing Cash of 30,926 If Tape Price is 25, December Closing Cash is 70,982

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One-way sensitivity analsysis

e.g. Sensitivity of closing cash to Rent per day

Dec Closing Cash =M26 2.00 Rent per Day 2.25 2.50 2.75 3.00 10.8 26.4 42.0 57.6 73.2

80.0 70.0 60.0 50.0 40.0 30.0 20.0 10.0 .0 2.00

Dec Closing Cash 000

2.25

2.50 Rent Per Day ()

2.75

3.00

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Two-way sensitivity analysis

Two-variable data table can be applied to a single cell such as December Closing Cash cell:
Plays per Month
50,954

2.00
-21,379 -13,333 -5,287 2,758 10,804

3.50
2,758 16,839 30,919 45,000 59,080

4.33
16,115 33,534 50,954 68,373 85,793

5.00
26,896 47,011 67,126 87,241 107,356

Rent per Day

2 2.25 2.5 2.75 3

120,000 100,000

Skywalker: December Closing Cash for different Rental & Plays per Month

Rental
80,000 60,000 40,000 20,000 0 1 -20,000 -40,000 2 3 4 5 6 2 2.25 2.5 2.75 3

Plays per Month

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3-D plot of two-way sensitivity analysis

Skywalker: Sensitivity of closing cash to to Rental & Plays per month

120

100

80
Closing cash 000

60

40

20

-20 3.00 -40 2.0 2.5 3.0 2.75 2.50 2.25 3.5 4.0 4.5 2.00 5.0 Rent per Day

Plays per Month

Tutorial on data tables in Datatables.xls

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Tornado diagrams

Helps us determine visually the main uncertainty drivers.

Assumptions Monthly Purchase Tape Price Tape Life Plays per Mth Rent per Day Shop Rent p a Interest p a Assumptions Optimistic Pessimistic
60 25 35 5.00 3.00 3,000 15 40 35 25 2.50 2.00 10,000 7

Impact on closing cash Optimistic Pessimistic

51.9 71.0 60.9 67.1 85.8 54.1 51.5 50.0 30.9 37.0 6.8 16.1 46.7 50.6

Rent per Day Plays per Mth Tape Price Tape Life Shop Rent p a Monthly Purchase Interest p a 20 40 60 80 100

Closing cash in 000

Tutorial on Tornado diagrams in Tornado.xls

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Constructing spider plots

Optimistic 60 20 35 5 3 3000 7 Base 50 30 30 4.33 2.5 6000 10 Pessimistic 45 40 35 40 27.5 25 3.165 2 2.25 2 8000 10000 13 15

Assumptions
MonthlyPurchase Tape Price Tape Life Plays per Mth Rent per Day Shop Rent p a Interest p a 55 25 32.5 4.665 2.75 4500 9

% change from base

MonthlyPurchase Tape Price Tape Life Plays per Mth Rent per Day Shop Rent p a Interest p a Optimistic 120 67 117 115 120 50 70 110 83 108 108 110 75 85 Base 100 100 100 100 100 100 100 Pessimistic 90 80 117 133 92 83 73 46 90 80 133 167 125 150

Closing cash results

MonthlyPurchase Tape Price Tape Life Plays per Mth Rent per Day Shop Rent p a Interest p a Optimistic 51.9 91.0 60.9 67.1 85.8 54.1 50.6 51.4 71.0 56.3 59.0 68.4 52.6 50.8 Base 51.0 51.0 51.0 51.0 51.0 51.0 51.0 Pessimistic 50.5 50.0 30.9 10.9 44.6 37.0 22.8 -5.3 33.5 16.1 48.8 46.7 51.2 51.5

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Skywalker: Spider plot

100.0

80.0

Closing cash 000

60.0

40.0

20.0

.0 % -20.0 50% 100% 150% 200%

% change from base

Tape Price Rent per Day MonthlyPurchase Tape Life Shop Rent p a Plays per Mth Interest p a

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Price/Demand Relationship

Price is a decision variable and demand should depend on price, e.g.

Plays per Month v Rental per Day
7 6 5

Plays per Month

4 3 2 1 0 1.5 2.0 2.5 Rent pe r Da y 3.0 3.5

Regression equation: PlaysperMonth = 13.13 - 3.80RentperDay One-way sensitivity analysis to Rent per day
60 40
Closing cash 000

20

1.00 -20 -40 -60

1.50

2.00

2.50

3.00

3.50

Rent per day ()

Which price maximises closing cash?

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Monte-Carlo simulation
Uncertain variables

Base Case Model

Uncertain Parameters Hours Flown Charter Price/Hour Ticket Price/Hour Capacity of Sch. flights Ratio of charter flights Operating Cost/hour Profit & Loss Income from Scheduled Income from Chartered Operating costs Fixed Costs Taxable profit Tax Profit after tax 259,200 224,000 (356,000) (60,000) 67,200 (22,176) 45,024 Base Value 800 700 90 60% 40% 445

Simulate
Output distribution

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Mercks Research Planning Model

Scientific, Medical constraints R&D variables

Monte-Carlo Simulation

Technological constraints

Manufacturing variables

Economic relationships

Marketing variables

Projections of variables Macroeconomic assumptions

Probability distributions for cash-flow ROI, NPV

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@RISK - How it works

Single simulation trial

INPUTS

MODEL CALCULATIONS Sales * Price - Cost

211 $5 $993

RESULT = Profit = $62

Multiple simulation trials

INPUTS MODEL CALCULATIONS
Trial 1: 211 * 5 - 993 = Trial 1: 193 * 8 - 700 = Trial 1: 219 * 6 - 999 = $62 $884 $315

RESULT
Profit

...
Trial N: 233 * 6 - 975 = $423

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Novaduct case

NOVADUCT SPREADSHEET FOR FIVE YEARS 1 2 MARKET 8000 8160 PRICE 7.0 7.4 V COST 5.0 5.2 SALES (MS) 1200 1248 NET REVENUE 2400 2834 FIXED COSTS -2000 -2060 CASHFLOW -2500 400 774

(cashflow in thousands) 3 4 5 8323 8490 8659 7.9 8.3 8.8 5.3 5.5 5.6 1298 1350 1403 3325 3879 4503 -2122 -2185 -2251 1203 1693 2252

ASSUMPTIONS Discount Rate Prod Cost Price Market Share MS Incr MktGrowth

15% 5 7 15% 0.3% 102.0%

103.0% 106.0%

RESULTS NPV IRR

1312 30%

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Novaduct - Uncertainty

Market share increase is equally likely to be any value between -0.2% and 0.8%

-0.2

0.8

Market growth is most likely to be a 2% increase but could range from a 10% decrease to an 8% increase

90

102 108

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Using @RISK

1. Introduce uncertainty into base model eg =RiskUniform(min, max) =RiskTriang(min, most likely, max) =RiskNormal(mean, std.dev.) 2. Select output cells (Cells for which we want simulation results) 3. Select simulation settings Number of iterations, random number seed 4. Execute simulation 5. View results Graphs, summary statistics 6. Return to spreadsheet and possibly repeat previous steps

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Novaduct using @RISK

ASSUMPTIONS Discount Rate Prod Cost Price Market Share MS Incr MktGrowth

15% 5 7 15% 0.3% 102.0%

103.0% 106.0%

=RiskUniform(-0.2%,0.8%) =RiskTriang(0.9,1.02,1.08)

@Risk Toolbar
Simulation settings Specify output cells Simulate

Open & Save Simulation Results

View input & output cells

View @RISK Window

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Simulation settings

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@RISK Window

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Simulation results
Distribution for IRR/F14
0.18 0.16

Distribution for NPV/F13

1.4E-01 1.2E-01

PROBABILITY

8.0E-02 6.0E-02 4.0E-02 2.0E-02 0.0E+00

00 0 0 0 0 00 00 00 00 50 00 -5 50 10 15 20 25 -1 -1 30 00

PROBABILITY

1.0E-01

0.14 0.12 0.1 0.08 0.06 0.04 0.02 0

0. 0

0. 1

0. 2

0. 2

0. 3

0. 4

Distribution for NPV/F13

Prob of Value <= X-axis Value

1.2
Prob of Value <= X-axis Value

1 0.8 0.6 0.4 0.2 0

0 -1 50 0 -1 00 0 -5 00 50 0 10 00 15 00 20 00 25 00 30 00

-0 .2 -0 .1 -0 .1

Distribution for IRR/F14

1.2 1 0.8 0.6 0.4 0.2 0
0. 0 0. 1 0. 2 0. 2 0. 3 0. 4 -0 .2 -0 .1 -0 .1 0. 4

NPV Mean 914 Max 3174 Min -1360 P(NPV<0) = 0.17 P(NPV<1,000) = 0.52

IRR Mean Max Min P(IRR<15%) = P(IRR<35%) =

25% 45% -14% 0.15 0.85

0. 4

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Cashflow Summary Graph

Central line connects mean values First band is 1 std.dev. Second band is interval between 5% and 95% percentiles

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Summary

Single point forecasts are dangerous! Challenge assumptions Scenario Planning Sensitivity analysis Data tables Tornado diagrams Monte-Carlo simulation Preparation for Workshop Datatables.xls and Tornado.xls @RISK tutorial Exercises