Beyond NPV – Simulation, Options and Trees Enterprise Risk Management Sensitivity Analysis Scenario Analysis Monte Carlo Simulation Real Options Decision Trees Market Values Economic Rents and Competitive Advantage Warren Buffet on Growth and Profitability

Credit Derivatives Total return swap Credit default swap One party pays interest and capital gains/losses Other party pays floating (or fixed) interest rate Credit default swap Fastest growing derivative Insurers and reinsurers heavily involved One party pays a periodic fee Other party pays any losses incurred in default or from credit downgrade Similar to insurance, but risk could be highly correlated

Operational Risk Causes of operational risk Internal processes People Systems Examples Product recall Customer satisfaction Information technology Labor dispute Management fraud

Strategic Risk Examples Competition Regulation Technological innovation Political impediments

Traditional Approach to Risk Management Risks are handled separately (silos) Corporate risk manager handles hazard risks CFO or investment department handles financial risks Managers handle operating risk CEO (or C-suite) handles strategic risk Each area has its own approach Terminology Risk tolerance Reports No overall coordination or aggregation

ERM Approach Aggregate Risk Management Hazard Risk Hurricanes Lawsuits Injuries Financial Risk Credit Risk Market Risk Interest Rates Operational Risk Internal Fraud Recalls Strategic Risk Regulation Reputation Competition

What is Driving ERM? Board of Directors concern about what can go wrong Regulators are evaluating all aspects of risk Rating agencies are considering a firm’s ERM policies Need for one person or group to be responsible for risk oversight Chief Risk Officer Technological advances Computing power Analytical techniques ERM is moving from risk control to risk optimization

Sensitivity Analysis Calculate the NPV of a project based on expected values Estimate optimistic and pessimistic values for each key variable Recalculate NPV by changing each key variable in turn Determine which variables could impact the investment decision Try to improve estimates for those variables

Problems with Sensitivity Analysis Meaning of “optimistic” and “pessimistic” How likely is each to occur Are terms used consistently Variables are not independent

Scenario Analysis Considers interrelations among variables Defines a set of potential developments Calculates the NPV for each situation Problems Limited number of scenarios No indication of likelihood of any scenario

Monte Carlo Simulation Determine the key variables that impact operations Develop a financial model to simulate cash flows Run multiple iterations Calculate the NPV of each iteration Evaluate the outcomes in aggregate Decide if the investment is acceptable given the potential NPV

Advantages and Disadvantages of Simulation Shows the results of many possible developments Indicates how likely any particular outcome is Considers the interrelations between variables Disadvantages Time consuming and costly to develop useful model Models need to be continually updated Over reliance on the model con lead to costly errors

Real Options Projects are usually not single decision situations Options include decisions to: Expand Abandon Defer Real options covered later (Chapter 22)

Decision Trees Shows each decision sequentially Provides for random elements for business conditions that will be revealed in future Work through trees from back to front

Decision Trees – Magna Charter Example 960 (.8) 220(.2) 930(.4) 140(.6) 800(.8) 100(.2) 410(.8) 180(.2) 220(.4) 100(.6) +150(.6) +30(.4) -550 NPV= ? Turboprop -150 +100(.6) +50(.4) or -250 NPV= ? Piston

Nuggets from Chapter 11 Use market values wherever possible Financial models will include errors Consider economic rents and competitive advantage Can Google protect its competitive advantage? Consider how competitors will react Warren Buffet on the automobile and airlines industries Look for long term economic advantage

Next Class Overview of Corporate Finance Read Chapter 14 Tuesday, February 27 Case 1 – Ben & Jerry’s Case is available in IUB on the course packet wall