When we talk about risk in valuation, we are concerned about the probability that cash flows will deviate from some estimated mean. In order to determine the appropriate mean and the possible deviations about that mean, we need methods for estimating the underlying cash flows.
One method for estimating cash flow means and variability is to identify determinate states of economic, political, cultural, and/or environmental conditions that impact the corporations ability to generate cash flows. For example, recessions and expansions in gross domestic product (or national income) are economic states of being that impact corporate sales and expenses. By defining the manner in which recessions or expansions impact sales and expenses, by identifying the most likely rate of change of sales and expenses under these two scenarios and the probability of each scenario, it becomes possible to construct pro forma income statements based on these estimates which provide a range of possible outcomes for the underlying cash flows. This range provides a basis for valuation analysis of the corporation or any specific project that is under review. This type of analysis is called scenario analysis. Other possible states of being that can be used in scenario analysis include alternative competitive conditions (e.g. an environment in which more or less foreign competition is allowed, due to changes in politically determined rules governing the degree to which markets are open to foreign competition); changes in weather conditions may impact certain types of production or service provision, impacting cash flows; or success or failure of a specific new product introduction, as in the example of Microsoft's new Windows 8 operating system, can be modeled as alternative scenarios.
Sensitivity analysis is related to scenario analysis, in that once we have identified determinate states of being to analyze, we can try out alternative assumptions about the relevant variables in each scenario. We can, in other words, explore the sensitivity of cash flows to different values and probabilities of such values under alternative scenarios. We can, however, also use sensitivity analysis in a single state of being. We would construct a spreadsheet that links various income items to some variable that we can adjust to see how the income statement changes with different resulting cash flows. This may be a useful managerial tool for internal corporate decision making. Corporate managers may, for instance, look at the way cash flows are likely to change if different types of information technology are deployed, each with a different impact on underlying sales and expenses.
An even better type of analysis is simulation analysis. Simulation analysis begins with the identification of those variable items that determine cash flows and the probabilities (perhaps based on past performance and/or estimates from production, marketing, and other internal departments) the variable items will take on certain values. In other words, we determine a probability distribution of values for the variable items that determine cash flows. We can think of a simulation as a sort of game model, in which these distributions are combined with random variables to allow us to play out the determination of cash flows over repeated iterations. This form of simulation is called a Monte Carlo experiment. If we can estimate a reasonable probability distribution for the underlying variable determinants of cash flows and then repeatedly run the experiment, then we get an estimate of the likely distribution of cash flows, the mean and standard deviation, from which we can then estimate risks associated with the project (or larger corporate porfolio of projects).
Practice Exercise in Sensitivity Analysis:
Global Fashions is a business partnership formed by two Mount Holyoke College (MHC) students. They have been selling clothing to Five College students since their junior year, designing the clothing themselves and subcontracting with a community organization in Holyoke for the manufacture of the apparel. However, the pair are now about to graduate. They are thinking about keeping the business, but will convert to a corporate structure under the new name Global Fashions International, Inc. (henceforth referred to as GFII). They will also expand capacity by shifting the subcontracting to a firm in Belize that was originally funded by the Belize Rural Women's Association and can produce the clothing at much lower cost and greater quantities than the community organization in Holyoke. GFII also plans to lease a space in the Village Commons (property that belongs to Mount Holyoke College). The cost of setting up the business in the Village Commons is $85,000. The former partners, now corporate owner-managers, are able to project cash flows for 5 years, using techniques learned in Economics 215: Corporate Finance at MHC. They estimate that the expansion will allow them to produce 1,000 quantity of various apparel at an average selling price of $65. The average cost per item of apparel from the subcontractor, including shipping costs, is $25. The lease costs $12,000 per year and is anticipated to rise 3% per year. The owner-managers believe they can raise prices by 3% per year. They estimate their subcontracting costs may also rise 3% per year. Assume that the entire initial investment in the business can be depreciated using the straight line method over five years. The required return of the owners (including relatives who have purchased shares in GFII) is 11% and GFII faces an effective tax rate of 30%.
a. Calculate the NPV for the business.
b. What happens if the subcontractor raises the average cost of the apparel by 10% right at the beginning?
c. What if college students are more fashion fickle than anticipated by our partners and they are only able to sell 800 pieces of apparel.
d. What if GFII has to lower prices by 10% in order to sell the product? How does this affect the value of the business?
e. What if GFII is able to raise prices by 5% per year, instead of 3%?