RISK ANALYSIS

By: Abhay Kanwar

Deepti Kumari
Manjot Singh
Ritesh Budgujjar
Vishal Burat

MONTE CARLO
SIMULATION

What is Monte Carlo

Simulation (MCS)?

Investopedia Says:

A problem solving technique used to approximate the

probability of certain outcomes by running multiple trial
runs, called simulations, using random variables. One of
the creators was fond of the casinos in Monte Carlo, hence
the name

MCS Is Used In

Science, engineering, portfolio management, and

business decision making

MCS was developed at Los Alamos National Labs during

nuclear bomb development

Which, as the photo indicates, is another way of saying,

MCS works

The general methods used tend to follow a particular

pattern:
1. Define a Domain of Possible inputs
2. Generate Inputs randomly from the domain using a
certain specified probability distribution
3. Perform a deterministic computation ( this means that
given a particular input it will always produce the same
output ) using inputs
4. Aggregate the results of the individual computations
into a final result

MCS Reduces Uncertainty

Forecasting anything, tomorrows weather, next months

sales, commission payouts in Q3, ROI on an investment
is difficult because it is about the FUTURE

For Many Forecasting is an

Unweighted Roll Up of

Informed and uninformed opinions

Negotiated compromises

Swags

Incentive compensation sand bagging

Projection of past performance to the future

And After All That Pain (And

Time)

Organizations often end up with a Single Point Estimate which is the

NUMBER, but that no one believes is the RIGHT number
Typical CFO After Preparing
A Forecast

MCS improves forecasting so lets discuss Distributions

Distributions?

To improve forecasts consider the estimates received

as a distribution of possible outcomes
You are familiar with some distributions

Normal Distribution (The Bell Curve) is a distribution

The Classic Best, Worse, Most Likely Case ( A Triangular

Distribution)

Binomial Distribution where an event either occurs or it

doesnt

Dont focus on a specific number, Focus on getting the

range, probabilities and shape of the distribution

Wait.Range?
Not This Kind of Range

Determine the range of possible outcomes I.E. The

boundaries

E.G. sales next quarter will not be less Than $1m because
next quarter the Smithson purchase is delivered

EG sales next quarter will not exceed $2m because $2m is

all the product that can be delivered

Probabilities?

What is the likelihood of a specific outcome?

Is it possible for outcomes beyond the range to occur?

Are some outcomes more likely than others?

Or do all outcomes have the same likelihood of

occurring?

Shape?

Considering the Range and Probabilities, What is the

Shape of the Distribution?

Is the Shape Normal or Triangular or Pert or Binomial?

Examples of each are below

A Simple Example

The CFO of a Software Reseller is preparing next

quarters forecast for 5 products

After discussions with Sales, Marketing and BizDev The

CFO creates the table on the next slide

Nice Table, But Which

Number Do You Forecast?
Software
Product
Ale

Worse

Most Likely

Best

15,000

30,000

50,000

8,000

22,000

30,000

Cataloger

10,000

20,000

25,000

Dolphin

12,000

18,000

40,000

Elasticity

25,000

50,000

100,000

Sum
Average of
Cases

70,000

140,000

245,000

Bonsai

151,667

Note that this table indicates the

range, the shape and the
probabilities.

How and What Would You

Decide?
Judgment?

Or Average? Or the
Most Likely?

Regardless

of choice, what
confidence is there that the
choice was rational and
defensible?

The next slide shows how you could decide

How About Running 10,000 Simulations and

Getting This Distribution (in Ten Seconds)

The Chart Isnt Interactive,

but Indicates

0% Probability of Exceeding Best Case-$245,000

67% Probability of Exceeding Most Likely Case-$140,000

80% Probability of Exceeding $133,000

90% Probability of Exceeding $126,000

100% Probability of Exceeding Worse Case-$70,000

Now Can You Decide What to Forecast?

Which Means?

To further increase confidence in the forecast, focus on

tightening the sales forecast for Elasticity

MCS not only increases confidence in the forecast it

helps prioritizes actions that increase confidence even
more!

Forecasting in Real Life Is

Complicated

Much more complicated than the simple model used in

this slide show

Real life models have thousands of inputs, not five

Many estimates dont fit into a Worse, Most Likely, Best

Distribution

Contingencies and Binominal Distributions are common

MCS Is A Powerful Tool

To improve forecasting

To identify priorities

To create more reliable forecasts

To increase confidence in models

Other Uses of MCS

Acquisition Modeling

Optimizing Inventory Stocking Levels

Portfolio Return Forecasting

Project Management Timelines

Pricing Decisions

And Yes, Building of Nuclear Weapons

Decision Tree

A Decision Tree is a
chronological representation of
the decision process.

A Visual Representation of
Choices, Consequences,
Probabilities, and
Opportunities.

A Way of Breaking Down

Complicated Situations Down
to Easier-to-Understand
Scenarios.

Decision
Tree
22

22

Decision Tree
The tree is composed of decision nodes, chance nodes &
the probabilities for various situations in chance nodes .

Decision
node

Chance
node

A branch emanating
from a decision node
corresponds to a
decision alternative. It
includes a cost or
benefit value.

P(S2)

P(S2)

23

A branch emanating
from a state of nature
(chance) node
corresponds to a
particular state of nature,
and includes the
probability of this state of
nature.

STEPS IN DECISION TREE

ANALYSIS:
Step 1
Identifying
the problem
and
alternatives

Step 2
Delineating
the decision
tree

Step 3

Step 4

Specifying
probabilities
& monetary
outcomes

Evaluating
various
decision
alternatives

Kaun Banega Crorepati

You are a contestant on Kaun Bangega Crorepati? You

already have answered the Rs. 25L question correctly and now
must decide if you would like to answer the Rs. 50L question.

You can choose to walk away at this point with Rs. 25L in
winnings or you may decide to answer the Rs. 50L question.

If you answer the Rs. 50L question correctly, you can then
choose to walk away with Rs. 50L in winnings or go on and
try to answer the Rs. 100L question.

If you answer the Rs. 100L question correctly, the game is over
and you win Rs. 100L. If you answer either question
incorrectly, the game is over immediately and you take home
only Rs. 3.2L.

You have the phone a friend lifeline remaining. With this option, you
may phone a friend to obtain advice on the correct answer to a question
before giving your answer.

You may use this option only once (i.e., you can use it on either the Rs.
50L question or the Rs. 100L). Since some of your friends are smarter
than you are, phone a friend significantly improves your odds for
answering a question correctly.

Without phone a friend, if you choose to answer the Rs. 50L

question you have a 65% chance of answering correctly, and if you
choose to answer the Rs. 100L question you have a 50% chance of
answering correctly (the questions get progressively more difficult).

With phone a friend, you have an 80% chance of answering the Rs.
50L question correctly and a 65% chance of answering the Rs. 100L
question correctly.

Kaun Banega Crorepati

Crt 50% 100

Decision
Point

Events

Decision
Point

3.2
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50L

Incrt 50%

Action

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80%

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3.2
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tu
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w/o Life
ife
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27

Kaun Banega Crorepati

Crt 50%

100L

51.60
Events
Decision Point

3.2L
Incrt 50%

50L

51.60
Action
Co

51.6

0%
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Dont Play

Crt 65%
Life
Use

line

100L

20%
Incorrect

41.92

3.2L
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Lif
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66.12

Incrt 35%
3.2L

44.10
Crt 50%
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66.12

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w/o Life
51.60

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25L

Decision Tree Example

.4

Expand
Factory
Cost = $1.5
M
Dont
Expand
Factory

.6

.4
.6

Cost = $0
NPVExpand = (.4(6) + .6(2)) 1.5 = $2.1M

40 % Chance of a
Good Economy,
Profit = $6M
60% Chance Bad
Economy, Profit
= $2M
Good Economy
(40%)
Profit = $3M
Bad Economy
(60%), Profit =
$1M

NPVNo Expand = .4(3) + .6(1) = $1.8M

$2.1 > 1.8, therefore you should expand the factory

PROJECT SELECTIO
UNDER RISK
Judgmental Evaluation
Payback Period Requirement
Risk Adjusted Discount Rate Method
Certainty Equivalent Method

JUDGMENTAL EVALUATION
Often, managers looks at the risk and return characteristics of a
project and decide judgmentally whether the project should be
accepted or rejected, without using any formal method for
incorporating risk in the decision making process. The decision
may be based on the collective view of some group like the
capital budgeting committee or the executive committee , or the
board of directors. Here the decision rely on judgment.

Payback Period
The

Payback Period is the ratio of the total cash to the

average per period cash. In simpler terms, it is the time

necessary to recover the cost invested in the project.

The

Payback Period is a basic project selection method. As

the name suggests, the payback period takes into

consideration the payback period of an investment. It is the
time frame that is required for the return on an investment to
repay the original cost that was invested. The calculation for
payback is pretty simple.

Payback Period

When the Payback period is being used as the Project

Selection Method, the project that has the shortest
Payback period is preferred since the organization can
regain the original investment faster.
There are, however, a few limitations to this method:

It does not consider the time value of money

The benefits that accrue after the payback period are not
considered, meaning it focuses more on the liquidity
while profitability is neglected.

Risks involved in individual projects are neglected.

Risk Adjusted Discount Rate

Method

The risk adjusted discount rate method calls for adjusting the
discount rate to reflect project risk.

If the risk of the project is equal to the risk of the existing

investment of the firm, the discount rate used is the average
cost of the capital of the firm.

If the risk of the project is greater than the existing

investment, the discount rate used is higher than the average
cost of the capital of the firm.

If the risk is less than the risk of existing investment, the

discount rate used is less than the average cost of capital of
the firm.

RISK ADJUSTED DISCOUNT RATE

METHOD
The risk adjusted discount rate is
rk = i + n + dk

rk = risk adjusted discount rate for project k.

i = risk free rate of interest.

n = adjustment for firms normal risk.

dk = adjustment for differential risk of project k

i+n = cost of capital

dk = may be positive or negative depending upon the risk of

the project under consideration compares with the existing risk
of the firm.

The adjustment of the differential risk of project k

depends on managements perception of the project risk
and managements attitude towards risk.
The project is accepted if its NPV is positive:
n

NPV

t=1

At - 1
(1+rk)t

Where, NPV is the net present value of project k,

At is the expected cash flow for year t, and

rk is the risk adjust discount rate of project k,

Example

The expected cash flow of project, which involves an investment outlay of

Rs.10,00,000 are:

Year

Cash flow (Rs.)

2,00,000

3,00,000

4,00,000

3,00,000

2,00,000

The risk-adjusted discount rate for the project is 18%

The net present value for the project is:

Example continued

Since the NPV is negative, the project is not

worthwhile.

The firms use different discount rates related

to risk factors for different type of
investment projects.

The discount rate is low routine replacement

investments, moderate for expansion
investments and high for new investments.

Limitations of risk
adjusted discount rate
method
Despite

its popularity, the method

suffers from two serious limitations:

It

is difficult to estimate dk consistently,

often it is determined in an extremely
ad-hoc and arbitrary manner.

This

method assumes that risk increases

with time at a constant rate.

CERTAINITY EQUIVALENT METHOD

It is a method which is used to calculate a guaranteed return

that someone would accept, rather than taking a chance on a
higher, but uncertain, return.

Under this method NPV is calculated as

NPV = sum(t*At/(1+i)^t)-I

t=certainty equivalent coefficient(0.5-1)

At=expected cash flow

i=risk free interest rate

I=initial investment

CEV Example
Vazeer Hydraulics Limited is considering
an investment proposal involving an
outlay of Rs.45,00,000. The expected cash
flows and certainty equivalent
coefficients are:

Year

Expected Cash Flow

Certainty
Equivalent
Coefficient

Rs.10,00,000

0.90

Rs.15,00,000

0.85

Rs.20,00,000

0.82

Rs.25,00,000

0.78

CEV Example

The

value of the certainty equivalent coefficient

usually ranges between 0.5 and 1.

value 1 implies that the cash flow is certain or

management is risk neutral.

But

in industries usually the cash flows are

uncertain and management is risk-averse. Hence
the certainty equivalent coefficients are typically
less than 1.

Certainty Equivalent
coefficients for Different
Year 1
Year 2
Types of Investments

Year 3

Year 4

Replacement investments

0.92

0.87

0.84

0.80

Expansion investments

0.89

0.85

0.80

0.75

New Product investments

0.85

0.80

0.74

0.68

Research and development

investments

0.75

0.70

0.64

0.58

RISK ANALYSIS IN
PRACTICE

RISK ANALYSIS
Most companies in India account for risk while evaluating their capital
expenditure decisions.
The following factors are considered to influence the riskiness of investment
projects:

Price of raw material and other inputs

Price of product

Product demand

Government policies

Technological changes

Project life

Inflation

RISK ANALYSIS
Four factors thought to be contributing most to the project
riskiness are:

Selling

price

Product

demand

Technical

changes

Government

policies

METHODS OF RISK ANALYSIS

Methods of risk analysis in practice are:

Sensitivity Analysis

Conservative Estimation of Revenues

Payback Method

Safety Margin in Cost Figures

Flexible Investment Yardsticks

Acceptance Overall Certainty Index

Judgement on Three Point Estimates

SENSITIVITY ANALYSIS &

CONSERVATIVE FORECASTS

Sensitivity analysis allows to see the impact of the change in the

behaviour of critical variables on the project profitability.

Conservative forecasts include using short payback or higher discount rate

for discounting cash flows.

Except a few companies most companies do not use the statistical and
other sophisticated techniques for analysing risk in investment decisions.

CONSERVATIVE ESTIMATION
OF REVENUES

In many cases, revenues expected from a project are conservatively

estimated to ensure that the viability of the projects is not easily
threatened by unfavourable circumstances.

The capital budgeting systems often have built-in devices for conservative
estimation.

PAYBACK METHOD

Payback method is a simple way to evaluate the number of years or

months it takes to return the initial investment

This method, as applied in practice, is more an attempt to allow for risk

in capital budgeting decision rather than a method to measure
profitability.

For Example:

Companies Sets a Payback period for new investments.

Any Deviation from the set payback period weeds out
the risky projects.

THE MERITS OF PAYBACK

The merits of payback

Its simplicity.

Focusing attention on the near term future and thereby

emphasising the liquidity of the firm through recovery
of capital.

Favouring short term projects over what may be riskier,

longer term projects.

Even as a method for allowing risks of time nature, it

ignores the time value of cash flows.

SAFETY MARGIN IN COST

FIGURES

A margin of safety is generally included in estimating cost figures.

This varies from 10-30% of what is deemed as normal cost.

Size of margin depends on what management

variation in the cost.

The following observation suggests this-

In estimating cost of raw material, we add about 20-25% to the current

prices as the raw material price is not stable and often we pay a high
price to get it. For labour cost, we add 10-12% as this is annual increase.

feels about the likely

FLEXIBLE INVESTMENT
YARDSTICKS

The cut-off point/Yardsticks for an investment varies as per the

judgement of the management about riskiness of the project.

In one company replacement investments are okayed if expected post-tax

return exceeds 15% but new investment is undertaken only if post-tax
return exceeds 20%. Another company employs a short payback period of 3
years for new investments.

ACCEPTABLE OVERALL
CERTAINTY INDEX

This is based on a few crucial factors affecting the success of the project.

Calculation of overall certainty index for a capital expenditure by firm

is given belowCertainty index%

Raw mat availability

70

Power availability

Freedom from competition

Overall certainty= (70+60+80)/ 3= 70

Project is accepted as 70% certainty level is satisfactory.

60
80

JUDGEMENT ON 3 POINT
ESTIMATES
In some companies three estimates are developed for one
or more aspects of the proposed investments. The top
management or board of the directors decide on the basic
of such information.
For Example: In a shipping company three estimates are
developed on basic of proposed investment.
Proposed investments:

High

Medium

low

EVALUATION

The methods of conservative estimation of revenues, safety margin in cost

figures and flexible yardsticks, in common practice, do not generally
employ explicitly defined probability distributions which seem alien to
current practices

The three point estimates and overall certainty index method however,
provide us with some idea of probability distribution making them
important in current practices.

RELATIVE IMPORTANCE OF
VARIOUS METHODS
A survey of corporate finance practices in India found the relative
importance of various methods of assessing project risk to be as
follows:
METHODS

PERCENTAGE

SENSITIVITY ANALYSYS

90.1

SCENARIO ANALYSIS

61.6

RISK-ADJUSTED DISCOUNT RATE

31.7

DECISION TREE ANALYSYS

12.2

MONTE CARLO SIMULATION

8.2

Source: Manoj Anand Corporate finance Practises in India: A

survey, October-December 2000