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Base Case and Sensitivity Analysis – “Waterfall and Tornadoes”

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Presentation on theme: "Base Case and Sensitivity Analysis – “Waterfall and Tornadoes”"— Presentation transcript:

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2 Base Case and Sensitivity Analysis – “Waterfall and Tornadoes”

3 I Deterministic & Sensitivity Analysis We create a model to evaluate alternatives and test the importance of uncertainties. Strategy Table Decision Structure Deterministic Analysis Probabilistic Analysis Appraisal Initial Situation Iteration Influence Diagram Deterministic Model ABC Deterministic Sensitivity Decision Tree Probability Distributions Value of Information Decision Quality

4 I Deterministic & Sensitivity Analysis We will discuss using spreadsheets for deterministic (base case) analysis and sensitivity analysis. Base Case Analysis and Waterfall Diagrams Sensitivity Analysis and Tornado Diagrams Using Sensitivity Results for Insight

5 I Deterministic & Sensitivity Analysis Base case* analysis gives an initial comparison of each alternative ABC Spreadsheet Model Base Case Inputs ¥ 1234 Base Case Outputs The important question is “Why is #3 best?” * All variables set at their “base case” values

6 I Deterministic & Sensitivity Analysis Another base case output—the cash flow plot—illustrates cash needs and yields from each alternative under consideration. –60 –50 –40 –30 –20 – Year Annual Cash Flow ($ millions) Run Out Moderate Investment Aggressive Investment The plot shows how moderate or aggressive investment extends mature product life, with economic break-even in 3–5 years.

7 I Deterministic & Sensitivity Analysis Initial evaluation with the model also yields important insights into sources of value and risk ABC Spreadsheet Model Base Case Waterfall of Value Sources of Value Uncertainty Range Tornado Diagram Sources of Risk

8 I Deterministic & Sensitivity Analysis Base case evaluation shows the net value of each alternative, in this case dealing with mature products investment alternatives. Net Present Value ($ millions) “Run Out” 71 Moderate Investment 291 Aggressive Investment 280 Why is the value of the aggressive investment less than the moderate investment?

9 I Deterministic & Sensitivity Analysis This horizontal “waterfall chart” shows incremental sources of value and cost for each strategy. Net Present Value ($ millions) , Run Out Moderate Investment Aggressive Investment Halo Revenues Product Revenues Key Added Value Promotion SF Reduced Value Product Revenues Halo Revenues SF Pr. Although typically drawn vertically, this orientation simplifies labeling.

10 I Deterministic & Sensitivity Analysis The waterfall chart can “break out” the base case value added or lost from each major source. Required Investment Net Present Value Market Growth New Products Fixed Costs Value from Future Sale Base Case NPV Business context: Purchase an existing business, add value, then sell. Current Contribution Contributions to Profit 0

11 I Deterministic & Sensitivity Analysis The elements of a waterfall correspond to the “value centers” of the influence diagram. Licensing Contribution Licensing Revenues Commission Costs Service Consulting Revenues Service Contribution Installation Costs Fixed Overhead Fixed Overhead Base Case NPV It’s best to “sketch” the waterfall in parallel with developing the influence diagram. Required Investment Net Present Value NPV Waterfall of Value Corresponding Influence Diagram 0

12 I Deterministic & Sensitivity Analysis The choice of “value centers” depends on the business context and the strategic decisions. Retail chain Existing stores New locations Biotech product company Product #1 Product #2 Upcoming product launch Research pipeline Global expansion opportunity North American contribution Europe Asia/Pacific Other regions Business portfolio Business unit, group, or sector #1 Business unit, group, or sector #2 Think of value centers as primary market segments or business centers or components of value, not cost centers.

13 I Deterministic & Sensitivity Analysis The waterfall is a good way to reconcile changes in a strategy’s valuation over time. Initial Valuation Data Revisions Revised Valuation May 27 Revised Valuation June 15 Competitor Exits Increase Fixed Overhead 0 Net Present Value

14 I Deterministic & Sensitivity Analysis Create the waterfall by working “backwards,” incrementally turning off sources of value. Contributions to Profit NPV Base Case Value 1 Value from Future Sale 2 Overhead 3 Product C 4 Product B 4 Product A Step 1Record base case NPV. Step 2Change future sales value to zero; record NPV. Step 3Set fixed and overhead costs to zero; record NPV. Step 4 Switch off product contributions one by one; record each NPV. Step 5With all products switched off, NPV should equal the required investment. 5 Required Investment 0

15 I Deterministic & Sensitivity Analysis One note about style: use short phrases on a “vertical bar” waterfall. Short sometimes. phrases can tell a powerful story Net Present Value You might be tempted to rotate text to add more words. 0

16 I Deterministic & Sensitivity Analysis Vertical text is OK in books and handouts, but it’s not effective in presentations. unless lying down! your audience happens to be Sideways text is not effective,

17 I Deterministic & Sensitivity Analysis The horizontal waterfall format accommodates many bars and lots of text. Net Present Value Look at all arrows & neat stuff you can write on this waterfall chart now that it’s oriented the “other” way. You run the risk of boring your audience of course, but if you write like Charles Dickens, you might consider this form of waterfall. You can also write in the arrow, or use text to help emphasize direction: Left! Right! And your audience doesn’t have to lie down! In here!

18 I Deterministic & Sensitivity Analysis The waterfall shows only base case values—it is equally important to understand which factors drive value higher or lower. Required Investment Contributions to Profit Value from Future Sale Base Case Value NPV Product A Product B Product C Overhead Uncertainties that Increase Value Uncertainties that Decrease Value 0

19 I Deterministic & Sensitivity Analysis We will discuss using spreadsheets for deterministic (base case) analysis and sensitivity analysis. Base Case Analysis and Waterfall Diagrams Sensitivity Analysis and Tornado Diagrams Using Sensitivity Results for Insight

20 I Deterministic & Sensitivity Analysis What do analysts in companies typically do when they encounter uncertainties? Ignore them Run three cases: base case, best case, worst case −How good is “best?” −How bad is “worst?” Make an “assumption” and proceed. −The “easy way out” −Are these justified? A “tornado” analysis provides the justification you need for leaving variables at their base values versus including their uncertainty explicitly in your analysis.

21 I Deterministic & Sensitivity Analysis Sensitivity (“tornado”) analysis identifies the primary sources of risk, which are then analyzed using probabilistic analysis. Decision Structure Deterministic Analysis Probabilistic Analysis Appraisal Iteration Many Uncertainties Tornado Primary Sources of Risk Initial Situation We also typically reassess ranges for the top bars in the tornado.

22 I Deterministic & Sensitivity Analysis Single-variable sensitivity analysis determines the change in model output when one input changes. Spreadsheet Model NPV ($ MM)75 OUTPUT Low Case 8% -6 High Case 28% 134 Swing 140 Market Share20% INPUTBase Case AB 1 2

23 I Deterministic & Sensitivity Analysis A “tornado diagram” graphically depicts the variables’ contributions to uncertainty in NPV. Net Present Value ($ millions) Base Value = 75 Price per dose Market Share Doses per Day Prevalence Rate Compliance Treatment Rate Development Cost COGS (%Rev) Uptake curve length Annual Price change $1.50$6.00 8%28% %3.0% 30.0%70.0% 30.0%60.0% %15% %1%

24 I Deterministic & Sensitivity Analysis The tornado diagram is generated by reevaluating NPV using low and high values for each variable separately. Base Case NPV = $75 MM Variable Variable Values Base 10% Low 90% High Price per Dose$3.50$1.50$6.00 Market Share20%8%28% Doses per Day213 Prevalence Rate2.0%1.5%3.0% Compliance55%30%70% Treatment Rate50%30%60% Development Cost COGS25%15%30% Uptake curve length537 Annual Price Change0%-2%1% Results “Low”“High”Swing

25 I Deterministic & Sensitivity Analysis Uncertain inputs can have a large effect on the output for two reasons. The input may be highly uncertain. Range of Input Range of Output Range of Input The output variable may be highly sensitive to small changes in an input. Range of Output {

26 I Deterministic & Sensitivity Analysis Three of the variables are “coupled” or “dependent.” They tend to vary together. We should determine the sensitivity of NPV to joint changes in these variables. Note: These scenarios are obtained by assessing a combination of events that would lead to a low (10th percentile) and a high (90th percentile) outlook. “Once a day” 1 70% $6.00 “bid”* 2 55% $3.50 “tid”* 3 30% $1.50 Number of Doses Compliance Price per Dose Price/Dosing Scenario *tid: ter in die – three times a day bid: bis in die – twice a day

27 I Deterministic & Sensitivity Analysis Joint sensitivity analysis determines the sensitivity of NPV to simultaneous changes in coupled* variables Variable Values Variable Doses per Day Compliance Price per Dose Low 3 30% $ 1.50 Base Case High 2 55% $ % $ 6.00 Base Case NPV = $75 MM Results “Low”“High”Swing * Coupled, or dependent, uncertainties are likely to vary together—either positively or negatively correlated.

28 I Deterministic & Sensitivity Analysis The updated tornado diagram focuses our attention on the most significant sources of risk. Net Present Value ($ millions) Base Value = 75 Market Share 8%28% Prevalence Rate 1.5%3.0% Treatment Rate 30.0%60.0% Development Cost COGS (%Rev) 30%15% Uptake curve length 7 3 Annual Price change -2%1% TIDBID Dose/Pricing Scenario Sensitive Insensitive We suggest re-assessing the uncertainty in the most sensitive uncertain variables and including them in probabilistic analysis.

29 I Deterministic & Sensitivity Analysis Uncertainties with the greatest “swing” are crucial to capturing the uncertainty in overall value. *The uncertainty in the model output (e.g., NPV) is proportional to the sum of the squares of individual input variable swings, if the variables are independent. 31Price Change TOTAL 35Uptake Curve 37COGS 48Dev Costs 79Treatment Rate 100Dose/Pricing Scen 101Prevalence Rate 140Market Share Individual Swing Uncertainty Variance (swing) 2 100%2% 98%2% 96%3% 93%4% 89%12% 77%19% 58%20% 38% Cumulative Contribution Contribution to Total Uncertainty*

30 I Deterministic & Sensitivity Analysis We will discuss using spreadsheets for deterministic (base case) analysis and sensitivity analysis. Base Case Analysis and Waterfall Diagrams Sensitivity Analysis and Tornado Diagrams Using Sensitivity Results for Insight

31 I Deterministic & Sensitivity Analysis The tornado diagram helps identify potential problems with the assessments and the model. Net Present Value Are these really the most sensitive, or are the ranges too wide? Too symmetric? Are experts biased? Low cost, high NPV!Cost:HighLow “Floating” bar— are the values right? Are these really low/zero swings, or is there a mistake? Does the base case match the waterfall (and spreadsheet) base case?

32 I Deterministic & Sensitivity Analysis Waterfall and tornado analyses provide tools to “mine” for NPV insights. Which risk factors might we be able to control? Is any strategy clearly most attractive? - How can we revise the strategy to capture more value? - How can we help focus the attention of company management? Where should the analysis be refined? What are the primary sources of value? What drives the uncertainty in net present value? What uncertainties have the greatest effect on decisions? Which variables are dependent?

33 I Deterministic & Sensitivity Analysis Change Log VersionDateChanges 0108/06/27First version for DAF - SDG LS (modified by M Seidler from DCW DSA v2.16) 0208/08/15Minimal changes after first DAF (Aug 2008) 0308/12/15Created Drug Development example to replace old Real Estate one (I Garrido) 0409/30/09Updated to IMS Template (MC) 507/21/10 Updated with minor revisions 606/07/12 Updated to IMSCG Template (LJ)

34 I Deterministic & Sensitivity Analysis Appendix

35 I Deterministic & Sensitivity Analysis There is another form of sensitivity—decision sensitivity; it identifies uncertainties that affect decision-making. How important is each uncertainty—enough to change our decision? Example: A Drug Development investment decision Invest Don’t Invest $ 0 Market Share Uncertainties Prevalence Price/dosing scenario

36 I Deterministic & Sensitivity Analysis The tornado identifies uncertainties that affect our choice between investing or not; this is called “decision sensitivity.” Variable Net Present Value Base Value: 75 Don’tInvest Don’tInvest Best Decision, Given: Low Input High Input We could change our decision based on the outcome Market Share and Dose/Pricing Scenario alone. These two are “decision sensitive.” Market Share Prevalence Rate Treatment Rate Development Cost COGS (%Rev) Dose/Pricing Scan 8% 28% 1.5%3.0% 30.0%60.0% % 15% TIDBID

37 I Deterministic & Sensitivity Analysis Judge the quality of available information before plunging into evaluation. 4 Clear Values and Trade-offs 5 Logically Correct Reasoning 6 Commitment to Action 0%100% Decision Quality 1 Appropriate Frame 2 Creative, Doable Alternatives 3 Meaningful, Reliable Information 3 Meaningful, Reliable Information Meaningful, Reliable Information: 0%“Blissful ignorance” Don’t know how much we know Ignoring uncertainty Ignoring “intangibles” 50%“Informed about uncertainty” Know information gaps Know what’s important Quantified uncertainty Interdependence not explored 100%“Knowledgeable and ready” Information correct and explicit Important gaps filled Know limits of knowledge


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