Risk Planning

Risk and uncertainty are part and parcel of most businesses. We need to understand these if we are ever to make rational business decisions.  

Quantitative Risk Analysis, using Monte Carlo simulation is one way of coming to grips with risk and uncertainty.   It is a powerful and precise method for assimilating the risks and uncertainties of a problem to produce a realistic appreciation of a problem and the risk associated with it.

Single point modeling (what you have when you put your “best guess” as a value in a spreadsheet)  provides one possible answer or solution, an answer that assumes the case that all the single variables in the spreadsheet are correct.   This is rarely the case.

Traditionally we attempt to overcome this by selecting various combinations for each input variable.   These various combinations are known as 'what-if' scenarios.   These combinations may include an expected maximum value, an expected minimum value and the best guess.   There are however physical drawbacks for attempting to do this for more than a few variables.   For example giving each of 4 variables a maximum, minimum and best guess would create 81 possible what-if scenarios and if you added one more variable to the mix, it would raise the number of possible scenarios to 243.

There has to be a better way, and there is:

Monte Carlo simulation and substituting single point deterministic modeled values with probability distributions for each value. This allows for us to consider whatever output we designate be it cash flow; NPV; EBIT; beta etc as a probability distribution.   A sensitivity analysis which is also derived from the simulation will bring to the fore those variables that need constant monitoring if performance is to be maintained.

For example: would it help to know that you not only have a 95% probability of exceeding an EBIT of $1,000,000 but that you also have a 60% probability of receiving more than $4,000,000.   Then again on a different project would it concern you to know that while you have a 60% probability of exceeding a $2,000,000 EBIT you also had a 20% probability of getting nothing and a 10% probability of showing a $500,000 loss?

Contact Allan Rodrigues of The Business Farm for more information on sensitivity analysis and the use of Monte Carlo Analysis