DRA/K V

Decision and Risk Analysis

Financial Modelling &
Risk Analysis

Kiriakos Vlahos
Spring 2000
 DRA/K V
Session overview

• Why do we need risk analysis?

• Project evaluation

• Risk analysis approaches

– Scenario analysis

– Sensitivity analysis

– Monte-Carlo simulation

• Summary
 Risk management in
DRA/K V

business

Corporate
risk

Capital budgeting
and portfolio
evaluation

Project Evaluation
 Why do we need risk
DRA/K V

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.
 Risk analysis
DRA/K V

approaches

• Scenario analysis

• Sensitivity analysis

• Monte-Carlo simulation

• Decision Analysis

• Option theory
 DRA/K V
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) 50
Tape Price £30
Tape Life (no of plays) 30
Plays per Mth (per tape) 4.33
Rent per Day £3
Shop Rent p a £6,000
Interest p a 10%
 DRA/K V
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

 DRA/K V
Base case model

SKYWALKER VIDEO MODEL

in £000 Jan Feb Mar Apr May Jun Jul Aug Sep Oct Nov Dec
Average Stock 1.0 1.1 1.1 1.2 1.2 1.3 1.3 1.4 1.4 1.5 1.5 1.6

Opening Cash 3.0 -22.2 -17.0 -11.5 -7.0 -.8 5.9 11.4 18.9 26.7 33.4 42.0
Rental recpts 10.8 11.4 11.9 12.4 13.0 13.5 14.1 14.6 15.2 15.7 16.2 16.8
Purchases -30.0 -1.5 -1.5 -1.5 -1.5 -1.5 -1.5 -1.5 -1.5 -1.5 -1.5 -1.5
Replacements -4.3 -4.5 -4.8 -5.0 -5.2 -5.4 -5.6 -5.8 -6.1 -6.3 -6.5 -6.7
Rent qtrly -1.5 -1.5 -1.5 -1.5

Total -22.0 -16.9 -11.4 -7.0 -.8 5.9 11.4 18.7 26.5 33.1 41.6 50.5
Interest -.2 -.1 -.1 -.1 .0 .0 .1 .2 .2 .3 .3 .4
Closing Cash -22.2 -17.0 -11.5 -7.0 -.8 5.9 11.4 18.9 26.7 33.4 42.0 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

 DRA/K V
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!

 Skywalker -
DRA/K V

Scenarios analysis

Assumptions Optimistic Base Pessimistic

Monthly Purchase 60 50 40
Tape Price 25 30 35
Tape Life 35 30 25
Plays per Mth 5.00 4.33 2.50
Rent per Day 3.00 2.50 2.00
Shop Rent p a 3,000 6,000 10,000
Interest p a 15 10 7

190,000
Skywalker Final Cash:
Comparison of Scenarios
140,000

90,000

40,000

-10,000
Jan Feb Mar Apr May Jun Jul Aug Sep Oct Nov Dec

-60,000
Optimistic Base Pessimistic
 DRA/K V
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
 DRA/K V
What-if analysis

• What-if Tape Price turns out to be 35?

Assumptions Results Panel:
Monthly Purchase 50 Final
Tape Price 35 Cash 30,926
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 Mar Apr May Jun Jul Aug Sep Oct Nov Dec
Average Stock 1.0 1.1 1.1 1.2 1.2 1.3 1.3 1.4 1.4 1.5 1.5 1.6

Opening Cash 3.0 -28.0 -23.8 -19.4 -16.1 -11.1 -5.6 -1.4 4.7 11.1 16.4 23.5
Rental recpts 10.8 11.4 11.9 12.4 13.0 13.5 14.1 14.6 15.2 15.7 16.2 16.8
Purchases -35.0 -1.8 -1.8 -1.8 -1.8 -1.8 -1.8 -1.8 -1.8 -1.8 -1.8 -1.8
Replacements -5.1 -5.3 -5.6 -5.8 -6.1 -6.3 -6.6 -6.8 -7.1 -7.3 -7.6 -7.8
Rent qtrly -1.5 -1.5 -1.5 -1.5

Total -27.7 -23.6 -19.2 -16.0 -11.0 -5.6 -1.4 4.6 11.0 16.2 23.3 30.7
Interest -.2 -.2 -.2 -.1 -.1 .0 .0 .0 .1 .1 .2 .3
Closing Cash -28.0 -23.8 -19.4 -16.1 -11.1 -5.6 -1.4 4.7 11.1 16.4 23.5 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
 One-way sensitivity
DRA/K V

analsysis

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

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

80.0
70.0
Dec Closing Cash £000

60.0
50.0
40.0
30.0
20.0
10.0
.0
2.00 2.25 2.50 2.75 3.00
Rent Per Day (£)
 Two-way sensitivity
DRA/K V

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 3.50 4.33 5.00
2 -21,379 2,758 16,115 26,896
Rent 2.25 -13,333 16,839 33,534 47,011
per 2.5 -5,287 30,919 50,954 67,126
Day 2.75 2,758 45,000 68,373 87,241
3 10,804 59,080 85,793 107,356

Skywalker: December Closing Cash

for different Rental & Plays per Month
120,000

100,000
Rental
80,000
2
60,000 2.25

40,000 2.5

20,000 2.75

3
0
1 2 3 4 5 6
-20,000

-40,000
Plays per Month
 3-D plot of two-way
DRA/K V

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

Tutorial on data tables in Datatables.xls

 DRA/K V
Tornado diagrams

Helps us determine visually the main uncertainty

drivers.
Assumptions Impact on closing cash
Assumptions Optimistic Pessimistic Optimistic Pessimistic
Monthly Purchase 60 40 51.9 50.0
Tape Price 25 35 71.0 30.9
Tape Life 35 25 60.9 37.0
Plays per Mth 5.00 2.50 67.1 6.8
Rent per Day 3.00 2.00 85.8 16.1
Shop Rent p a 3,000 10,000 54.1 46.7
Interest p a 15 7 51.5 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

 Constructing
DRA/K V

spider plots

Assumptions
Optimistic Base Pessimistic
MonthlyPurchase 60 55 50 45 40
Tape Price 20 25 30 35 40
Tape Life 35 32.5 30 27.5 25
Plays per Mth 5 4.665 4.33 3.165 2
Rent per Day 3 2.75 2.5 2.25 2
Shop Rent p a 3000 4500 6000 8000 10000
Interest p a 7 9 10 13 15

% change from base

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

Closing cash results

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

100.0

80.0
Closing cash £000

60.0

40.0

20.0

.0
% 50% 100% 150% 200%

-20.0
% change from base
Tape Price Tape Life Plays per Mth

Rent per Day Shop Rent p a Interest p a

MonthlyPurchase
 Price/Demand
DRA/K V

Relationship
Price is a decision variable and demand
should depend on price, e.g.
Plays per Month v Rental per Day
7

5
Plays per Month

0
1.5 2.0 2.5 3.0 3.5
Rent pe r Da y

Regression equation:
PlaysperMonth = 13.13 - 3.80RentperDay

One-way sensitivity analysis to Rent per day

60

40
Closing cash £000

20

1.00 1.50 2.00 2.50 3.00 3.50

-20

-40

-60
Rent per day (£)

Which price maximises closing cash?

 DRA/K V
Monte-Carlo simulation

Uncertain variables
Base Case Model

Uncertain Parameters Base Value

Hours Flown 800
Charter Price/Hour 700
Ticket Price/Hour 90
Capacity of Sch. flights 60%
Ratio of charter flights 40%
Operating Cost/hour 445

Profit & Loss

Income from Scheduled £259,200

Income from Chartered £224,000

Operating costs (£356,000)

Fixed Costs (£60,000)

Taxable profit £67,200

Tax (£22,176)

Profit after tax £45,024

Simulate
Output distribution
 Merck’s Research
DRA/K V

Planning Model

Scientific,
Medical
Monte-Carlo
constraints
Simulation
R&D
variables
Technological
constraints

Manufacturing
variables Economic
relationships
Probability
distributions
Marketing Projections for cash-flow
variables of variables ROI, NPV

Macro-
economic
assumptions
 DRA/K V
@RISK - How it works

Single simulation trial

INPUTS
MODEL
CALCULATIONS RESULT

Sales * Price - Cost = Profit

= $62
211

$5

$993

Multiple simulation trials

INPUTS
MODEL
CALCULATIONS RESULT
Profit
Trial 1: 211 * 5 - 993 = $62

Trial 1: 193 * 8 - 700 = $884

Trial 1: 219 * 6 - 999 = $315

...
Trial N: 233 * 6 - 975 = $423
 DRA/K V
Novaduct case

NOVADUCT SPREADSHEET FOR FIVE YEARS (cashflow in thousands)

1 2 3 4 5
MARKET 8000 8160 8323 8490 8659
PRICE 7.0 7.4 7.9 8.3 8.8
V COST 5.0 5.2 5.3 5.5 5.6
SALES (MS) 1200 1248 1298 1350 1403
NET REVENUE 2400 2834 3325 3879 4503
FIXED COSTS -2000 -2060 -2122 -2185 -2251
CASHFLOW -2500 400 774 1203 1693 2252

ASSUMPTIONS RESULTS
Discount Rate 15% NPV 1312
Prod Cost 5 103.0% IRR 30%
Price 7 106.0%
Market Share 15%
MS Incr 0.3%
MktGrowth 102.0%
 DRA/K V
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
 DRA/K V
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
 DRA/K V
Novaduct using @RISK

ASSUMPTIONS
Discount Rate 15%
Prod Cost 5 103.0%
Price 7 106.0%
Market Share 15% =RiskUniform(-0.2%,0.8%)
MS Incr 0.3%
MktGrowth 102.0% =RiskTriang(0.9,1.02,1.08)

@Risk Toolbar

Simulation Specify
settings output cells Simulate

Open & Save View input View @RISK

Simulation & output cells Window
Results
DRA/K V
Simulation settings
DRA/K V
@RISK Window
 DRA/K V
Simulation results

Distribution for NPV/F13 Distribution for IRR/F14

1.4E-01 0.18
1.2E-01
0.16
0.14
PROBABILITY

1.0E-01

PROBABILITY
0.12
8.0E-02
0.1
6.0E-02 0.08
4.0E-02 0.06
2.0E-02 0.04
0.0E+00 0.02
0
00
0

00

00

00

00

00
50

00

50
-5

10

15

20

25

30
-1

-1

Distribution for NPV/F13 Distribution for IRR/F14

1.2 1.2
Prob of Value <= X-axis

1
Prob of Value <= X-axis

1
0.8 0.8
Value

Value

0.6 0.6
0.4 0.4
0.2 0.2
0 0
0

00

00

00

00

00
0

0
00
50

00

50
10

15

20

25

30
-5
-1

-1

NPV IRR
Mean 914 Mean 25%
Max 3174 Max 45%
Min -1360 Min -14%
P(NPV<0) = 0.17 P(IRR<15%) = 0.15
P(NPV<1,000) = 0.52 P(IRR<35%) = 0.85
 Cashflow Summary
DRA/K V

Graph

• Central line connects mean values

• First band is 1 std.dev.
• Second band is interval between 5%
and 95% percentiles
 DRA/K V
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