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You are on page 1of 8

Risk Analyzer

The first step is to create a model of your study. This is an Excel workbook that you

create that has the following:

Cells that you use to enter numeric values. Examples of such cells are:

Budget for the accounting group

Budget for the marketing group

Budget for the administrative group

Investment to build a building

Selling price of a product

Amount of a product to be sold

Cost to make a product

These cells are referred to as input cells or input variables or

sensitivity variables. Input cells are cells that contain just

numbers.

Cells that contain formulas and return a value that you are interested in.

Examples of such cells are:

The total of all the budgets

The return on investment

These cells are referred to as output cells or output variables. Output

cells are cells that contain formulas.

The Risk Analyzer identifies such cells by the use of range names. Range names are a

feature of Excel that assigns a name to a cell. If you move the cell, the name moves

with it.

To create a name select a cell and click in the name box which is to right of the formula

box and has the cell address in it. Then type a name, with no spaces. After you type in

the name, press enter - do not click elsewhere as you must press enter to create the

name Once you have created the name, the cell address in the name box is replaced by

the name you create. Instead of spaces, use underscores, "_"

The alternate way to create a range name is to select a cell and then press

CTL-F3. In the dialog that appears, type in a name (no spaces allowed) and

click on the ADD button. You will notice that Excel often suggests a logical

name.

To better understand creating range names, practice creating them a new workbook.

Type some text or number entries in several cells and then create a range name for each

cell using the approaches above.

BASIC STEPS IN RISK ANALYSIS IN EXCEL

Investment Study Example

Do not create the range names in this file. as the

names that are needed have already been created.

Your models (Excel workbooks) can be as simple as you want or as complex as you

want. The budget example that comes with the Risk Analyzer is a very simple model.

The investment example is more complex.

Once you have created your model, the next steps are to:

Create a risk analysis premise file

Define and create probability distributions

Create and review the sensitivity variable reports

Run simulations

Fine tuning histograms and output table appearance

A risk analysis premise file is a workbook that stores the key assumptions on your

risk analysis. It is created and used by the Risk Analyzer via a series of questions and

dialog selections.

Probability distributions represent the likelihood that a given value will occur. The

higher the peak of the cure, the more likely a value associated with the peak will occur.

The following pictures reflect some of the probability distributions one can use.

The normal distribution represents variables whose values are

most likely to be in the middle of the range, and with values

away from the middle equally likely to happen in either

direction.

A beta distribution is similar to a normal, but skewed to the left

or to the right, and the values away from the center have a

greater likelihood of happening.

A uniform distribution is one you would use when any value

along a range of values has an equal likelihood of happening.

A gamma distribution is highly skewed

in one direction or another.

A triangular distribution is often the easiest to create, as you

decide on the min, max, and most likely values. It often weights

the values away from the most likely value heavier than the normal

or gamma distributions, which puts more "risk range" in your study.

In addition to the above distributions, the Risk Analyzer allows you to create

exponential distributions, Poisson distributions, discrete distributions and custom

distributions. Most Risk Analysis studies do not use these distributions.

Although the normal distribution is the one most taught in school and college, the

gamma distributions and the triangular distributions are the ones that are most often

representative of the distribution of real world variables.

The option to create sensitivity reports gives you a documentation page on the

probability assumptions you have made in your study. And it creates sensitivity charts.

The following illustrates a typical probability curve. The area under the black curved line

is the likelihood that a value will occur. The blue lines are the + or - 10% points, called

the 10/90 points. There is a 20% chance that the input variable will be outside of the

10/90 points, with it being 10% likely that it will be less then the smaller 10/90 point and

a 10% chance it will be greater than the larger 10/90 point. The red line represents the

value in the study file.

The sensitivity charts that the Risk Analyzer creates are just a way to show which

variables have the biggest effect on the outcome of your study. They also show if

the assumptions on the variables are skewed toward an optimistic view or a pessimistic

view of the world.

A sensitivity chart looks like the following:

Expected Profit Sensitivity To Key

Variables

0

10,000

20,000

30,000

40,000

50,000

60,000

E

x

p

e

c

t

e

d

P

r

o

f

i

tConstruction_

Cost

Demolition

Environmental

Engineering

Equipment_R

entals

The horizontal line represents the study case. The vertical lines represent the output variable range between the sensitivity variables' 10/90 values. Sensitivity variables

with long vertical lines have the most effect on the output variable.

Construction Cost

Study Min Max

File Allowed Expected Allowed

Value Value 10/90 Value 10/90 Value

520,000 470,000 508,188 526,327 541,393 550,000

Gamma right distribution

460,000 480,000 500,000 520,000 540,000 560,000

27% <= Study value

The horizontal line represents the case you have set up in your Excel model.

Typically, it is the most likely case. Sometimes, it is the case that

management wishes were the most likely case.

Each vertical line represents the change in the output variable due to a change

in an input variable. The end points represent the input variable values that have

a 10% chance of occurring or a 90% chance. Often these points are referred to

as the 10/90 points and 90/10 points..

Examination of such charts give you a feel for which variables affect the outcome

and in what direction.

The Risk Analyzer does all the work when you run simulations. All you do is select

which variables to use in the study and how many simulations to run. Typically, you

would run 3000 to 5000 simulations, which would take 1-3 minutes.

As nice output is always important, the option to fine tune the histograms and tables

which are the main output is easy to do.

The next worksheet will walk you through the risk analysis of the investment study.

Expected Profit Sensitivity To Key

Variables

0

10,000

20,000

30,000

40,000

50,000

60,000

E

x

p

e

c

t

e

d

P

r

o

f

i

tConstruction_

Cost

Demolition

Environmental

Engineering

Equipment_R

entals

The horizontal line represents the study case. The vertical lines represent the output variable range between the sensitivity variables' 10/90 values. Sensitivity variables

with long vertical lines have the most effect on the output variable.

Risk Analyzer Example File Instructions

GENERAL

This is one of three example files to use with the Risk Analyzer. You should print this

sheet so that you have it as a guide when you use the Risk Analyzer.

The sheet titled 'Investment Study" contains an economic model of investing in

manufacturing facilities to make a product. The purpose of this example file is to determine

the likely return on investment (IRR) that the company will get from their investment.

CREATING A RISK ANALYSIS PREMISE FILE

The first step is to create a risk analysis premise file. Do so by selecting the option to

do so from the Risk Analyzer menu. Specify this file as the study file.

When prompted for the title, you may use the default title (the name of this file)

or specify any title you wish

You will next be asked to specify your output variables. Two are listed on the

selection form:

Net_Present_Value (primary output variable)

Rate_Of_Return

Select both and click ok.

Once you select these, you will then be prompted to select your primary output

variable. This variable is used to sort the sensitivity variables in order of importance.

Select Net_Present_Value as the primary output variable.

You will then be prompted for the input or sensitivity variables. All those listed

may be selected. They are:

Fixed_Cost_Per_Year

Investment

Marketing_Cost_Percent

Price

Shipments_Per_Year

Variable_Cost_Per_Unit

Save the file once it is created.

INSTRUCTIONS FOR USING THIS EXAMPLE

page 5

Risk Analyzer Example File Instructions

DEFINING AND CREATING PROBABILITY DISTRIBUTIONS

Once you save the risk analysis premise file, click on the Risk Analyzer button to display

the main menu.

Select the option to define/change sensitivity variables probability distributions. Please use

the following distributions, minimum values, and maximum values. Use the X axis

minimum to improve the appearance of the graphs

The minimum and maximum values are input on the first dialog when you initially set a variable's

distribution. They can be changed on the distribution dialog. The X axis minimum are input

on the distribution dialog. Typically, you do not need to set X axis maximums.

Sensitivity Min Max X Axis

Variables Distribution Value Value Min

Fixed_Cost_Per_Year Normal 10,000 20,000 10,000

Investment Beta 40,000 75,000 40,000

Marketing_Cost_Percent Uniform 5.0% 10.0% 0.0%

Price Gamma Left 6.00 7.00 5.50

Shipments_Per_Year Gamma right 7,000 10,000 6,000

Variable_Cost_Per_Unit Triangular 2.75 3.50 2.00

The distribution dialog shows a chart of the probability of a distribution. The more area under

the curve, the more likely values in that range are likely to occur.

CREATING PROBABILITY DISTRIBUTION CHARTS

You can use the option on the Risk Analyzer menu to create the sensitivity variables

distribution report. This allows you to confirm that the distributions are what you want. It

also provides a report that you can use to share with others.

CREATING SENSITIVITY CHARTS

Once you have defined the distributions, use the options on the Risk Analyzer menu to

create the sensitivity charts. These charts plot the expected values of the output

variables assuming that a sensitivity variable is set to its 10% and 90% values. This range

represents 80% of the likely values of a sensitivity variable.

If a sensitivity value falls outside its 10/90 range, its sensitivity line will not intersect

the expected value line.

When the sensitivity charts are created, the variance contribution for each variable is calculated.

The variance contribution indicates how much each sensitivity variable affects the value of your

primary output variable.

page 6

Risk Analyzer Example File Instructions

RUNNING SIMULATIONS

Once the above are created, select the option to run simulations. Specify 3000 simulations

and select all the variables. The simulation run will typically take one to two minutes to

run. You should select the sensitivity variables in descending order of their variance

affect on your primary output variable. This variance is shown in column A next to the

sensitivity variable. It is calculated by the Risk Analyzer when the sensitivity charts

are created.

You may get a message at the end of the simulation runs that advise that some of

the output variables could not be calculated This typically happens if your model is

calculating a return on investment (or similar value) and Excel can not find a solution.

To avoid, you may need to write equations for IRR like those illustrated at the bottom

of the sample file's Economics worksheet.

If the number of output variable that can not be solved is small, then the results of the

simulations for that variable are valid. If a significant number of the cases can not be

solved, then the results may be skewed and you should modify your formulas (as

illustrated on the Economics worksheet) to provide solutions. To help you test your

modifications, the Risk Analyzer provides debug options to set your study to a given

case and to reset back to the base case values.

3000 simulations runs is typically all that you need. If the distribution histograms

that are created are not smooth, you can make additional runs. If you have already

made a set of runs, you are given the option to make additional runs. We

recommend that you make an additional run of 2000 more simulations so that you

see how this works.

If you change your model, you should always use the start over / clear option. If you

do not, the results will not be representative of your model.

FINE TUNING HISTOGRAMS

Once you have run enough cases to get an understanding of the range of your output

variables, you can use this information to customize the histograms. For example, you

may want to set the start and end value for the bins, and the step size. Setting these

values give a much more professional appearance to your output. On the Risk Premises

sheet, change the histogram settings from "auto" to the following:

When you specify such values in your studies, you should have at least 10 bins, and

preferably 20 or more bins.

Use the fine tune histogram option to redo the histograms.

If you change the format of the output variable in your study file, then the appearance

of the from-to values on the histograms will reflect this change if you re-create the

histograms. To illustrate this, format the Rate of Return cell to 0% (no decimal) and

recreate the histogram via the fine tune histogram option.

Output

Variables Min value Max value Step size

Net_Present_Value (75,000) 100,000 5,000

Rate_Of_Return -30% 50% 2%

Histogram settings

page 7

EXCEL SPREADSHEET MODEL

Yellow cells are the 26,077 Net Present Value 20.6% Rate of Return

sensitivity cells

2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013

PREMISES:

Shipments per year 9,000 9,000 9,000 9,000 9,000 9,000 9,000 9,000 9,000 9,000

Price Per unit 6.50 6.50 6.50 6.50 6.50 6.50 6.50 6.50 6.50 6.50

Variable Cost Per Unit 3.00 3.00 3.00 3.00 3.00 3.00 3.00 3.00 3.00 3.00

Fixed Cost 15,000 15,000 15,000 15,000 15,000 15,000 15,000 15,000 15,000 15,000

Marketing Cost as % of Revenue 8.0% 8.0% 8.0% 8.0% 8.0% 8.0% 8.0% 8.0% 8.0% 8.0%

Investment 58,000

FINANCIALS:

$'s $'s $'s $'s $'s $'s $'s $'s $'s $'s $'s

Revenue 58,500 58,500 58,500 58,500 58,500 58,500 58,500 58,500 58,500 58,500

Cost:

Variable Cost 27,000 27,000 27,000 27,000 27,000 27,000 27,000 27,000 27,000 27,000

Fixed Cost 15,000 15,000 15,000 15,000 15,000 15,000 15,000 15,000 15,000 15,000

Depreciation 5,800 5,800 5,800 5,800 5,800 5,800 5,800 5,800 5,800 5,800

Marketing Costs 4,680 4,680 4,680 4,680 4,680 4,680 4,680 4,680 4,680 4,680

—— —— —— —— —— —— —— —— —— ——

Total Cost 52,480 52,480 52,480 52,480 52,480 52,480 52,480 52,480 52,480 52,480

Pre Tax Earnings 6,020 6,020 6,020 6,020 6,020 6,020 6,020 6,020 6,020 6,020

Taxes 2,288 2,288 2,288 2,288 2,288 2,288 2,288 2,288 2,288 2,288

—— —— —— —— —— —— —— —— —— ——

After Tax Earnings 8,308 8,308 8,308 8,308 8,308 8,308 8,308 8,308 8,308 8,308

Cash Flow By Year (58,000) 14,108 14,108 14,108 14,108 14,108 14,108 14,108 14,108 14,108 14,108

IRR CALCULATIONS

Initial Guess none -0.1 -0.2 -0.3 0.1 0.2 0.4

IRR 21% 21% 21% 21% 21% 21% 21%

this approached used as the default initial guess may

not be close enough to converge to a solution

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