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MBA 253 Sensitivity and Scenario Analysis 2012-13

construction economics

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Praveen Kumar Ray
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74 views

MBA 253 Sensitivity and Scenario Analysis 2012-13

construction economics

Uploaded by

Praveen Kumar Ray
Copyright
© © All Rights Reserved
We take content rights seriously. If you suspect this is your content, claim it here.
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Download as PPT, PDF, TXT or read online on Scribd
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Sensitivity and Scenario

Analysis
Financial Modeling
Any model we use has the potential to have
error
How do we account for the uncertainty
associated with our inputs into the model?
Three Types of Risk
Stand Alone Risk
Views project in isolation
With-in firm (Corporate Risk)
Looks at the firms portfolio of projects and how
they interact
Market Risk
Risk from the view of a well diversified investor.
Definitions
Risk
Exposure to a chance of injury or loss
Probability
The likelihood an event occurs
Risk vs. Uncertainty
Risk the probability of the outcome is known
Uncertainty includes judgment concerning the
probability

Definitions and Terms Continued
Objective Prob can measure prob. precisely
Subjective Prob. Includes judgment or
opinion
Variation Risk We want to look at a range
of possible outcomes

Issues in Risk Measurement
1. Stand Alone Risk is the easiest to measure
2. Market Risk is the most important to the shareholder
3. To evaluate risk you need three things
i. Standard deviation of the projects forecasted
returns
ii. Correlation of the projects forecasted returns with
the firms other assets
iii. Correlation of the projects forecasted returns with
the market
Issues in Risk Management cont
4. Using the numbers in 3) you can find the corporate
beta and market beta coefficient (equal to ((s/s)r)
5. Most projects have a + correlation with other
projects and a coefficient < 1
6. Most projects are positively correlated with the
market with coefficient < 1
7. Corporate risk should also be examined
1. More important to small business
2. Investors may look at things other than market risk
3. Firm Stability is important to creditors, suppliers etc


Stand Alone Risk (Review)
The easiest approach to measuring stand alone
risk is to use the standard deviation of the
projects returns.
Just like security analysis you need to be careful
looking at only standard deviation dont forget
coefficient of variation

Measuring Stand Alone Risk
Sensitivity Analysis

Scenario Analysis

Monte Carlo Simulation
Sensitivity Analysis
Looks at the change in your decision variable
when one input changes.
Examples:
what happens to the value of a project if sales
are 10% higher than expected.
What happens to the cost of capital if the risk
free rate increases.
Example 1
Basic time value of money problem.
Assume you believe you need 2,000,000 when
you retire and you are now 25 years old.
How much will you need to deposit each year at
the end of the year if your account earns 8%
each year?
$27,357.56
Example 1 Change ONLY
Expected return
What if your estimated rate of return is of by 10% of the
base (What if your account earns 8.8% each year?
Or 7.2% each year)?
Rate Payment
7.2% $24,322.44
8% $27,357.56
8.8% $30,724.44
Example 2: change ONLY
Amount Needed for Retirement
Now assume that the amount you need for retiremetn
may be off either way by 10%


Savings Needed Payment
1,800,000 $24,621.80
2,000,000 $27,357.56
2,200,000 $30,093.31
Sensitivity Analysis
Usually the results are represented in a table
where the response of the decision variable to
changes in more than one individual variable
are reported.
Then you can compare across variables to see
which one has the largest impact on your
decision
Example Results

Change in Payment needed for Retirement
Savings Needed Expected Return
+10% $24,621.80 $24322.44
Base $27,357.56 $27,357.56
-10% $30,093.31 $30,724.49
Sensitivity Analysis
Benefits
a. Easy to Calculate and Understand
b. Measures risk associated with individual inputs
Weaknesses
a. Ignores probability of event
b. Ignores interaction among the variables
c. Ignores gains from diversification


Scenario Analysis
Differences from Sensitivity Analysis
Allows you to change more than one variable at
a time
Look at a group of scenarios (best case, base
case, and worst case) for example worst case
what if all variables change against us by 20%.
Includes probability estimates of each scenario

Scenario Analysis
Now let both the future cash flows and the cost of
capital change.
Worst Case Scenario Best Case Scenario
(Savingsh Returni) (Savingsi Returnh)
Need $2,200,000 Need $1,800,000
Return = 7.2% Return = 8.8%
PMT = 33,796.89 PMT = $21,890.20
Scenario Analysis
Given the NPV and Probability you can find
the expected NPV and standard deviation
Scenario NPV Prob. NPV(Prob)
Worst $33,796.89 .33 $11,265.63
Base $27357.56 .33 $ 9,119.17
Best $21,890.20 .33 $ 7,296.73
Expected NPV $27,681.55
Standard Deviation $ 5,959.95
Interpreting the Results
The project has an expected return on
4204.94 with standard deviation of 741.38
This implies a 68 % confidence interval of
(3463.56 to 4946.32) a large range of
possible outcomes
The coefficient of variation would be .1763
(you are accepting .1763 units of risk for
each unit of return)

Scenario Analysis
Benefits
1. More than one variable changes at a time
2. Accounts for probability
3. Easy to perform
Weaknesses
1. Small number of scenarios is unrealistic
2. Probability distributions difficult to estimate

Monte Carlo Simulation
A more advanced form of scenario analysis
Utilizes the computer to make random choices
for each variable input then calculate the
expected return and standard deviation
Mont Carlo Simulation
1. Construct a model of the firms cash flows and
NPVs
2. Specify a probability distribution for each
uncertain variable (characterized by mean and
standard dev) and correlation among variables.
3. Allow computer to select a random draw form the
distribution for each variable
4. Calculate NPV (this is one scenario).
5. Repeat 3) an 4) (10,000 or 100,000 times) equal
chance of each scenario Calculate expected NPV
and standard deviation.

Monte Carlo Simulation
Benefits
1. More realistic selection of variables
2. Easy to understand results
Weaknesses
1. Only as good as probability estimate and
correlation of variables
Quick Review
Sensitivity Analysis Scenario Analysis and
Monte Carlo Simulation were all used to
measure stand alone risk
Each is designed to provide more information
about the uncertainty associated with the
project they do not provide a clear cut
decision rule.

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