1. 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

2. 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

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

4. Strategic Risk Examples Competition Regulation
Technological innovation
Political impediments

5. 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

6. 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

7. 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

8. 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

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

10. 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

11. 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

12. 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

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

14. 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

15. 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

16. 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

17. 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