MBAD/F 619: Risk Analysis and Financial Modeling Instructor: Linda Leon Fall

Overview of Financial Modeling Financial statements report what happened to the firm in the past (Accounting) Financial models look forward to the future: Financial planning models (pro forma models) predict future financial statements results Cash models project short term cash balances Portfolio models predict the return/risk of portfolios Option models anticipate future stock prices

Financial Modeling: An Overview of Relationships Between Inputs and Outputs Special Analysis Investment Data Investment Data Ratio Analysis Ratio Analysis Fund Flow Analysis Fund Flow Analysis Financial Model (computer program) Financial Model (computer program) Financial Data Financial Data Operating History and Future Assumptions Manufacturing or Service Inputs Manufacturing or Service Inputs Staff Inputs Staff Inputs Sales Inputs Sales Inputs Pro forma Statements

Defining Risk Two ingredients are present when risk exists (Holton, “Defining Risk”, Financial Analysis Journal, 60(6), pp 19-25, 2004): Uncertainty about outcomes Different outcomes provide different utility Standard deviations  and betas  used to measure uncertainty Distribution assumptions measure probability of an outcome A comprehensive definition incorporates the probability and the consequence of outcome

Dealing with Risk Hedging risk: Reducing risk exposures to undesirable outcomes Insurance Options Reject investment: “No-go” decision Managing risk: Hedging some risks while also taking advantage of upside potential through strategic risk taking

Risk Management Applications Investment Decisions Portfolio Strategies: Asset Allocations Asset Selection Performance Evaluation Financing Decisions Project Investment Decisions Financing Decisions Dividend Decisions: Working Capital Management Cash Budgeting

Valuation The value of a business underlies the decision-making for all investment and financing decisions: Want to identify companies that trade at below “fair” value for investments Want to make decisions that increase firm value Value is determined by expected cash flows and discount rate Good models will allow risk to be incorporated into its cash flows, growth rates and discount rates

Decision Support Models require the developer to Be explicit about the objectives of the model and the assumptions being made Identify decision parameters that influence objectives Think carefully about which variables to include and their relationships to other variables Consider what data is needed

Two Prescriptive Analytical Approaches for Financial Modeling Simulation Process of imitating the firm so that the possible consequences of alternative decisions and strategies can be analyzed prior to implementation Optimization Identifies which decision alternative leads to a desired objective given a specified set of fixed assumptions

Financial Modeling Many financial models which use advanced modeling and analytical techniques are spreadsheet based There is a market demand for more sophisticated models and analysis by financial end-users Most end-users prefer to develop their own models (cost,flexibility)

Advantages of End-User Modeling End-users get closer to the raw data and the assumptions being made End-users can customize the models to generate information that fits their needs End-users can see results easily and immediately, which enhances strategy generation and encourages risk analysis

Disadvantages of End-User Modeling Incorrect information is generated by inappropriate or inaccurate models (20 to 40% contain significant errors) End-users are overconfident about the quality of their own spreadsheets Poorly designed models can discourage strategy generation and risk analysis End-users may not always employ the most productive methods for generating insights or may misinterpret the generated information

Recent spreadsheet research shows… End users typically do not plan their spreadsheets End users rarely spend time debugging their models End users almost never let another person review their spreadsheets Many end users do not consistently use tools that can make modeling productive and insightful

Course Objectives: Students should be able to Identify, assess and quantify business risks and recommend strategies to manage risk Develop and use appropriate financial planning spreadsheet models to analyze various financial applications involving uncertainty

As well as…. Apply advanced analytical skills in modeling and decision-making with an emphasis on Monte Carlo simulation and optimization Integrate the information provided by the use of simulation and optimization into the decision-making process and be aware of the limitations of the information provided