Methods Of Risk Assessment For Corporate Managers

Sensitivity Analysis

Question:

Discuss About The Deemed Occur Predicted Corporate Manager?

Uncertainty hovers over every project when it is started and determination of risks is key for making decisions which is required by the managers. Big companies are known to incorporate tough ways to tackle risks in case of capital budgeting (Gitman, Juchau and Flanagan 2015). Therefore, every manager should know the methods of risk assessment. The main jobs of corporate managers are to marketing profits for their company but they should also know how to mitigate risks.

One of the several methods for identifying risks is sensitivity analysis which assists in showing the alterations in NPV related to the applied change of a variable given as input on the contrary when other things stay the same (Slagmulder, Bruggeman and Wassenhove 2013). Input variables are determined with their base value by the managers to conduct sensitivity analysis. The base value is the most relevant value which is deemed to occur predicted by the corporate manager.

When determination of base value is done then requirement of testing the net present value of the sensitivity of the cash flow is there which is related to the variation in variable concerned with some percentage of units that keeps other variables constant. It is important to note that the change in values must be made keeping the relation of amount of products sold and cost in mind (Burns and Walker 2015). It can be argued that, sensitivity analysis is the key in showcasing the effect of changes which occur in taking assumptions. It must be mentioned that sensitivity analysis supports decision making for various capital budgeting. It also helps the managers to notice how the possible NPV are distributed and the impact perceived by the internal return rate of the project which is under discussion. It also oversees the influence in a specific input variable. At any given time, managers taking the decisions are needed to create assumptions regarding the project in a way that time taken, amount of sales units in the project and the capital cost is considered.

Corporate managers need to know about the authenticity of the assumptions and the expected changes in the final outcome of the project so that they cannot make incorrect assumptions (Fama 2014). The process of measurement of sensitivity of the outcomes taking part in the speculations for the project is known as Sensitivity analysis. In this, alteration of one speculation is done to keep others intact which will determine the changes which will occur in NPC and IRR. Cash flows are being foretold by the managers at the time of capital budgeting.

Scenario Analysis

Sales forecast and the cost are the fundamentals on which other systems of cash flow forecasting is done. Sales volume and selling price of a unit is reflected by the sales revenue. Market shares of the organization and size of the market depends of the sales volume of the concerned project. Analysis of the tax cash flow done by the concerned managers determines the IRR and NPV (Grob 2013). This is computed by adding different variables of discount, cash flows, rate and project life. Hence it can be said that each variable is uncertain in most cases. Variables which are set for the project are sensitive and their degree if sensitivity is determined by doing sensitivity analysis. Therefore, the sensitivity of IRR and NPV is determined by the analysis about alterations in a specific variable. 

As depicted in scenario analysis, one variable is changes at appoint of time. Since all variables are correlated, as they must be to be relevant in all cases when each scenario portrays different combination of variables. Scenario analysis is termed as the approach of behaviour and is same as sensitivity analysis but has a wider perspective (Brunzell, Liljeblom and Vaihekoski 2013). It calculates the effect which a change in organization brings when the numbers of variables are changed such as capital cost, cash inflow and outflow. For example, the company may determine the low and high values of the NPV of the concerned project. Individual scenario assists in showing the various stages of NPV with variables such as cash inflow, capital cost and cash outflow.

NPV estimates can be used by the managers with the prospect of risk evaluation related to the project concerned with the degree of inflation. During decision making process, the managers are unsure of their assumptions. Some of those assumptions can alter the course of problems and its specifics (Hartman 2014). It is known facts that sensitivity analysis is the most popular technique of capital budgeting but it come with some limitations. But these uncertainties are resolved through scenario analysis. It incorporates the possibilities with the respective variables and provides the managers with a chance to change numerous variables at one time.

Most certain set of variables taken as input variables make the base method of Scenario analysis. Then it moves towards the worst case scenario slowly and then jumps to the best case scenario (Fama 2013). Accounting mentioned that there are some daring managers who get carried away with the most certain results and ignore the possibilities some vague assumptions can create which may be fluctuations in the economy and uncertain reactions of the competitors. All the possible outcomes can be taken into account through Scenario analysis including best case and worst case scenarios.

Break-even Analysis

There are four important points to be considered in the analysis. In the primary stages, determination of factors which will be foundations for assuming scenarios is done. These factors may be the economic condition and the competitor’s reaction on any business activity of the company (Titman and Martin 2014). The second factor consists of establishing various scenarios which needs to be analysed by keeping each factor under consideration. In usual practice, there are three basic factors the first one is the best case scenario, second one is average case scenario and the last one is the worst case consequence. The third factor is considered by focusing on important factors and establishing specific consequence for every factor (Baños-Caballero, García-Teruel and Martínez-Solano 2014). Each factor is given a certain probability which will make the final component. The macro-economic factors such as rate of interest, rate of exchange and factors of micro economics and reactions of the competitors compute to make the assignments. Analysis of each and every scenario is done at the time of preparing NPV.

Managers do the sensitivity analysis in which they come against the problem about the status of the project when the sales will decrease or the cost will increase. Production quantity and the minimum rate of sale are to be known by the managers in any case so that the project does not incur loss (Higgins 2012). This phenomenon is called break-even-analysis and the least quantity which needs to be produced to evade loss is the break-even-point. In terms of capital budgeting the project which is at the break-even is as good as the business which givers zero percent return.

An individual or a company both get their return of the actual investment in the above mentioned scenario. But the factor of time value of money is not compensated and there is no reimbursement of the value of risk which was taken by the investor. If seen in different context, managers tend to let go of their cost of opportunity of capital invested. Hence, it can be stated that the project which breaks even accords negative NPV (Brealey, Allen and Mohanty 2012). Breakeven analysis is a better place to start but it ignores some of the most important information. It is oblivious to the matters of possibilities of acquiring proper results or how the outcome will result into. It can be seen by managers as a big winning opportunity by ignoring the possibility of losing some money. Therefore it can be said that Break-even analysis stresses more on NPV and ignores the aspects of profits made by accounting.

Monte Carlo Simulation Analysis

Analysis done of the scenario and the sensitivity are known to be the best models for knowing the uncertainties of investment in the projects. Hence it can be noted here that both the above mentioned models do not consider the relationship between the variables and ignores the possibilities of alterations in the variables (Aebi, Sabato and Schmid 2012). There is method called Monte Carlo Simulation Analysis which helps the computer in adding the risks involved in capital budgeting.

The name Monte Carlo is given because the method which contains numbers, driven randomly from the distribution possibilities. It is known to be statistics based method that applies numbers which are random and previously given possibilities which can change the result of the entire project and its gains (Brigham and Houston 2012). It requires high end functionality of the computer to work in efficient manner. Analysis done for simulation is varied from the basic concept of sensitivity analysis in ways that differ from estimation of important variables, probable distribution of values for every variable is applied. 

The process of simulation structure generation starts from the computer that calculates simultaneous values in a random manner for every known variable which might be same as the model of project life, market, sale price, growth rate and cost of the variable etc. In the guidance of set of values which are randomly selected a new order of cash flow is generated and fresh NPV is calculated (Wang and Sarkis 2013). The same method is applied on different places which can go to few hundred times or even greater than that if the project is huge. The managers are equipped with this procedure to make project decisions on the variations of possibilities regarding the NPV of the project.

Distribution model shows that the mean value of NPV will be calculated and the relevant standard deviation will be applied the take account of the level of risk taken in the project (Brigham and Ehrhardt 2013). When the possible outcomes are distributed, then the manager gets the chance of seeing the continuum of all possible results rather than just getting a single estimate. It is imperative to note here that Monte Carlo Simulation includes the possibilities and the sensitivities coming in distribution. The most important aspect of this structure is that it allows the managers and stakeholders to take note of the possibilities of NPV distributions in place of a single estimate of the concerned NPV (Arnold 2013). Strength of simulation analysis makes its impact on the differences as it properly tackles all the problems of many exogenous entities involved in any kind of distribution. It forces the managers to consider the indecisions and uncertainties explicitly that are involved in the projects of capital budgeting.

Conclusion

The above mentioned discussion emphasis on methods used in capital budgeting which are mainly rooted on the speculations and uncertainty. All the decisions of investments made by the managers are going to be constructed on the establishment of various important matters which includes market value of the company, cash flow generated by the company and dividends paid.

Methods used in capital budgeting gives the managers the options as they are equipped with accurate details which are compiled with much precaution and carefulness so that if they are used then they should not create problems when the circumstances change which may be of economic or technological nature. In those circumstances the evidences produced by the computer can be of much help and can save the day for the managers.

Reference

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