Chapter 11: Risk Analysis and Monte-Carlo Simulation

2007 Pearson Education

Risk Analysis

Risk analysis is an approach for developing an understanding of risk in making decisions Data tables simple but do not capture randomness and uncertainty Monte-Carlo simulation powerful technique for incorporating uncertainty into risk analysis

Financial Analysis Model

Uncertain inputs

Output variables

Typical Risk Analysis Questions

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What are the chances that the store would not be profitable by the third year? How likely is it that cumulative profits over five years would not exceed $100,000? What profit are we likely to realize with a probability of at least 0.70?

Monte-Carlo Simulation
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Build a model for a decision problem Recognize and identify uncertainty associated with model variables Generate a probability distribution for outcome variables Analyze the effects of uncertainty in the outcome variables.

Monte-Carlo Simulation With Crystal Ball

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Develop a spreadsheet model Define assumptions for probabilistic variables Define forecast cells the output variables of interest Set the number of trials and run preferences Run the simulation Interpret results

Financial Model Example: Define Assumptions

First year sales revenue: normal, mean = $800,000, standard deviation = $70,000, minimum = $650,000 Annual growth rate, year 2: lognormal, mean = 20%, standard deviation = 8% Annual growth rate, year 3: lognormal, mean = 12%, standard deviation = 4% Annual growth rate, year 4: lognormal, mean = 9%, standard deviation = 2% Annual growth rate, year 5: lognormal, mean = 5%, standard deviation = 1% Cost of merchandise: uniform between 27% and 33% Labor cost: triangular, minimum = $175,000, most likely = $200,000, maximum = $225,000 Rent per square foot: uniform between $26 and $30 Other expenses: triangular, minimum = $310,000, most likely = $325,000, maximum = $350,000 Inflation rate: triangular, minimum = 1%, most likely = 2$, maximum = 5%

Crystal Ball Distribution Gallery

First Year Sales Normal Distribution Assumption

Lognormal Assumption for Annual Growth Rate

Uniform Assumption for Cost of Merchandise

Triangular Assumption for Inflation Rate

Define Forecast Dialog

Run Preferences Trials

Crystal Ball Forecast Chart

Evaluating Risk

Drag grabber or enter values in box

Probability Interval

Percentiles View

Statistics View

Computing a CI

A 95 percent confidence interval for the mean would be $122,199 1.96($2826) or [$116,660, $127,738]

Sensitivity Chart Contribution to Variance View

Trend Chart

Overlay Chart

Reports and Data Extraction

Create customized reports from the Analyze menu Extract data into an Excel worksheet Statistics Percentiles Chart Bins the intervals in the forecast chart along with their probability and frequency of occurrences. Sensitivities sensitivity data for all pairs of assumptions and forecasts Trial Values the generated assumption and forecast values for each simulation trial.

Crystal Ball Functions

Click on the function wizard button in Excel and select Crystal Ball 7 for a complete list.

Other Crystal Ball Tools

Tornado and Spider Charts Correlation Matrix Bootstrap Tool Batch Fit Scenario Analysis 2D Simulation Decision Table

Application Retirement Planning

Retirement Planning Results

Newsvendor Model

Illustrative Newsvendor Result

Hotel Overbooking

Overbooking Model Forecast Charts

Using the Decision Table Tool

Cash Budgeting Model

Trend Chart Results

Project Management

Crystal Ball Model

Probability of On-Time Project Completion