RISK ANALYSIS TECHNIQUES

SENSITIVITY ANALYSIS
This involves observing what happens to a dependent variable (such as the objective function,
NPV) as a change occurs in a particular variable. For example, NPV may depend on market
size, market share, and sales price. Sensitivity analysis could tell us what happens to NPV as we
change market size by one unit (any sized unit); or how NPV changes as we change market share
by one unit; and so forth.
Use of Sensitivity Analysis: Sensitivity analysis provides an estimate of the impact of a change
in a variable on NPV. This is helpful in determining whether a better estimate of that variable is
important. So, we mind find that a change in variable X significantly affects NPV, but a change
in Y does not. Then we might want to focus on X (see problems with sensitivity analysis
below). This could mean getting a better fix on the probability distribution of X, or on
influencing the probability distribution of X (e.g., by changing the nature of the investment, by
risk management through hedging, etc.). In contrast, under these circumstances we will not
likely be very interested in Y. Of course, when we decided that the NPV does not depend much
on Y, we would want to make sure that we tested the effect of Y on NPV over a wide range of Y
(because how NPV reacts to Y may depend on the level of Y).
Problems with Sensitivity Analysis: There are two key problems with sensitivity analysis.

Interrelated Variables: The variables that describe a firm are generally interrelated. So
examining the change in one variable at a time does not replicate reality and may be highly
misleading. For example, suppose that we find that a small change in X (holding all other
variables, including Y, constant) produces a big change in NPV. We might conclude that
NPV varies a lot with X. But, what if, when X increases, Z also increases, and that an
increase in Z reduces NPV (offsetting the effect of X)? To illustrate, suppose that X is sales
and Y is costs. When sales increase (holding everything else, including costs, constant),
profit and NPV go up. But, when sales go up, costs go up, and this may offset (or more than
offset) the increase in sales; NPV may actually decline with the rise in sales due to the
associated increase in costs. A sensitivity analysis of the effect of sales on NPV would
completely ignore the related changes in costs.

Probability: Another problem is that sensitivity analysis does not incorporate probability,
only sensitivity. So, an increase in X might cause a big increase in NPV, but an increase in
X may be extremely improbable. Focusing on X may therefore be a waste of time even
though it appears to be a key driver of NPV.

SCENARIO ANALYSIS
Scenario analysis involves the examination of alternative scenarios that might unfold for an
investment. If performed properly, this technique produces the same NPV as does the standard
discounted expected cash flow NPV approach.
Use of Scenario Analysis
Signify the proper risk-adjusted discount rate (WACC) for analyzing the investment as k, the
future time t expected cash flow as CF t , and the expected initial (time 0) outlay to undertake
the investment as I 0 . The maximum possible life of the investment is signified as n. Equation
(1) states the NPV as it is typically computed (signified here as NPV[standard]):
n

CF t

(1 k )

NPV[standard] =

t 1

I0

(1)

NPV[standard] in (1) is the projects NPV as we normally compute it, which is projects
expected future cash flows discounted at the appropriate risk-adjusted discount rate k minus the
expected initial outlay for the project. In most cases, the initial outlay is assumed to be known
and equal to some amount I 0 (i.e., I 0 = I 0 in (1)).
An alternative way to compute an NPV, which we will refer to as NPV[scenarios] , is:
m

NPV[scenarios] =

DCF[scenario i] Pr

i 1

(2)
where m is the number of potential scenarios that might unfold for the investment. In (2), Pri is
the probability that scenario i will occur, and

CFti
i

I
DCF [scenario i] =
0
t
t 1 (1 k )

n (i )

(3)

In (3), I 0 is the initial outlay under scenario i, CFti is the time t cash flow under scenario i, and
n(i) is the life of the investment under scenario i. DCF[scenario i] in (3) is not an NPV; it is a
computation that looks like an NPV. It is the discounted cash flows only for scenario i. The
NPV of the investment takes into account all of the possible scenarios for the investment. The
investments NPV is NPV[scenarios] in (2); NPV[scenarios] is the probability-weighted sum
over all possible scenarios.
It can be shown that the two methods of computing an NPV ((2) and (3)) produce the same NPV,
that is:
NPV[standard] = NPV[scenarios]

(4)

To illustrate, assume a project with a known initial outlay of $100, that is, I 0 = $100 (all figures
in $million). One of three scenarios might unfold: worst case, middle case, best case. Exhibit 1
below provides the data about these scenarios. Assume that the discount rate k = 10%.
Exhibit 1. Three Scenarios (all dollar amounts in $million)
CFt for all
Scenario
Probability
CF1
CF2
t>2
Worst case
.2
$5
$7
$9
Middle case
.5
$6
$8
$12
Best case
.3
$8
$10
$14
So, in the worst case (which has a 20% probability of occurring), in the first year the cash flow
will be $5, in the second year the cash flow will be $7, and for all years after that (in perpetuity)
the cash flow will be $9. Similarly for the middle case and the best case.
Solving the problem the usual way using equation (1), the expected cash flows and NPV are:
CF1 = .2($5) + .5($6) + .3($8) = $6.40
CF 2 = .2($7) + .5($8) + .3($10) = $8.40

(5a)
(5b)
(5c)

CF 3 = .2($9) + .5($12) + .3($14) = $12.00

n

CF t

(1 k )

NPV[standard] =

t 1

I0

$8.40

1 $12
$6.40
+

2 +
2
$100
1.1
(1.1)
(1.1) .10

= $11.93

(6)

Now lets use equation (2). The DCF[scenario i] computations for the three scenarios are:
$5

$7

$9

$12

$14

DCF[worst case] =
+
2 +
2
$100 = $15.29
1.1
(1.1)
(1.1) .10
$6

(7b)

$8

DCF[middle case] =
+
2 +
2
$100 = $11.24
1.1
(1.1)
(1.1) .10
$8

(7c)

(7a)

$10

DCF[best case] =
+
2 +
2
$100 = $31.24
1.1
(1.1)
(1.1) .10
m

NPV[scenarios] =

DCF[ scenario i] Pr

i 1

= ( $15.29)(.2) + ($11.24)(.3) + ($31.24)(.3)

= $11.93

(8)
3

Problem with Scenario Analysis: The major problem is that there may be many plausible
scenarios and computing the variable values for each is a tedious matter unless a complex
computer model is used. But, if a complex computer model is used, why not go the full mile and
use simulation?
SIMULATION
Simulation is the artificial replication of something real. Monte Carlo simulation involves
assigning probability distributions to some or all of the variables that are input in the simulation,
and then generating a probability distribution output for one or more variables (such as cash
flow). Simulation can be very useful in evaluating a large investment project.
What Should Be Simulated? Have the computer simulate (produce as output) each future
periods cash flow probability distribution, and the parameters of that distribution (mean,
variance, correlation with the market, autocorrelation, etc.). These simulated data are inputs in
the determination of the investments risk-adjusted discount rate (k) and NPV.
If k is Uncertain: There is generally some degree of uncertainty about the appropriate k to use in
the NPV computation. A good way to deal with this is to assign (or simulate) a probability
distribution for k. Then we can generate a probability distribution of NPVs using the various
possible ks to discount the expected cash flows. If all the NPVs for all plausible ks are positive,
we can probably conclude that we have a winner. If all the NPVs for all plausible ks are
negative, we can probably infer that we have a loser. If the NPV is positive for some ks and
negative for others, we have a problem. In this case, we may want to gather more information in
order to improve the estimate of the k and the cash flows.
If k is Known: If the expected cash flows have been estimated and the appropriate k to discount
those expected cash flows is known, the single unique NPV of the project can be computed using
(1). For any given discount rate and series of expected cash flows, there is a single NPV. The
discount rate adjusts for the risk of the project; and the expected (mean) cash flow estimates are
affected by the entire probability distribution of the cash flows (i.e., that expected cash flow
takes into account low cash flow outcomes as well as high cash flow outcomes). The NPV is our
current estimate of the net gain from adopting the investment.
Sometimes it is argued that, even if the expected cash flows and the k are known, it is useful, in
assessing a projects risk, to generate a probability distribution of the projects NPV computed
using the risk-free rate as the discount rate. This exercise is not productive. An NPV probability
distribution in this case is meaningless because discounting a risky cash flow using the risk-free
rate produces a number that has no economic meaning. Furthermore, the NPV of a project does
not have a positive variance probability distribution if the k and the expected cash flows are
known. Under these conditions, there is only one NPV (the probability distribution assigns a
probability of 1.0 to the computed NPV).

10/26/2003