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Beyond NPV – Simulation, Options and Trees

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.

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Beyond NPV – Simulation, Options and Trees

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

  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 • Advantages • 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 0 -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

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