Module 1: FINANCIAL RISK MANAGEMENT

Learning Objectives

After studying this chapter, you should be able to:

1. Explain the concept of risk management.

2. Know the basic principles, elements, and processes of risk management.
3. Explain the alternative potential risk treatments.
4. Enumerate the areas of risk management.
5. Enumerate and explain the types of investment risks.
6. Understand and apply the techniques and models commonly used in assessing investment alternatives
under risk or uncertainty.

Introduction

Risk Management is the process of measuring or assessing risk and developing strategies to manage it. Risk
management is the systematic approach in identifying, analyzing and controlling areas or events with a potential for
causing unwanted change. Risk Management is the act or practice of controlling risk. It includes risk planning,
assessing risk areas, developing risk handling options, monitoring risks to determine how risks have changed and
documenting overall risk management program.

As defined in the International Organization of Standardization (ISO 31000), Risk Management is the identification,
assessment, and prioritization of risks followed by coordinated and economical application of resources to minimize,
monitor and control the probability and/ or impact of unfortunate events and to maximize the realization of
opportunities.

It is through risk management that risks to any specific program are assessed and systematically managed to reduce
risk to an acceptable level. Risks can come from uncertainty in financial market, project failures, legal liabilities,
credit risks, accidents, natural causes and disasters as well as deliberate attack from adversary or events of uncertain
or unpredictable root- cause.

Basic Principle of Risk Management

The International Organization of Standardization (ISO) identifies the basic principles of risk management.

Risk Management should:

1. Create Value- Resources spent to mitigate risk should be less than the consequences of inaction, i.e., the
benefits should exceed the costs.
2. Address uncertainty and assumptions.
3. Be an integral part of the organizational processes and decision- making.
4. Be dynamic, iterative, transparent, tailorable, and responsive to change.
5. Create capability of continual improvement and enhancement considering the best available information
and human factors.
6. Be systematic, structured and continually or periodically reassessed.

Process of Risk Management

According to the standard ISO 31000 “Risk Management- Principle and guidelines on implementation, “the process
of risk management consists of several steps as follows:

1. Establishing the Context. This will involve

a. Identification of risk in a selected domain of interest
b. Planning the remainder of the process.
c. Mapping out of the following:
i. The social scope of risk management
ii. The identity and objectives of stakeholders
iii. The basis upon which risks will be evaluated, constraints,
d. Defining a framework for the activity and an agenda for identification.
e. Developing an analysis of risks involved in the process.
f. Mitigation or solution of risks using available technological, human and organizational resources.
2. Identification of potential risks. Risk identification can start with the analysis of the source of problem or
with the analysis of the problem itself. Common risk identification methods are:
a. Objective- based risk
b. Scenario- based risk
c. Taxonomy- based risk
d. Common- risk checking
e. Risk charting

3. Risk assessment. Once risks have been identified, their potential severity of impact and the probability of
occurrence must be assessed. The assessment process is critical to make the best educated decisions in
prioritizing the implementation of the risk management plan.

Elements of Risk Management

In practice. The process of assessing overall risks can be difficult, and balancing resources to mitigate between risks
with a high probability of occurrence but lower loss versus a risk with high loss but lower probability of occurrence
can often be mishandled. Ideal risk management should minimize the spending of manpower or other resources and
at the same time minimizing the negative effect of risks.

For the most part, the performance of assessment methods should consist of the following elements:

1. Identification, characterization, and assessment of threats.

2. Assessment of the vulnerability of critical assets to specific threats.
3. Determination of the risk (i.e., the expected likelihood and consequences of specific types of attacks on
specific assets).
4. Identification of ways to reduce those risks.
5. Prioritization of risk reduction measures based on strategy.

Potential Risk Treatments

ISO 31000 also suggests that once risks have been identified and assessed, techniques to manage the risks should be
applied. These techniques can fall into one or more of these four categories:

 Avoidance
 Reduction
 Sharing
 Retention
Risk Avoidance

This includes performing an activity that could carry risk. An example would be not buying a property of business in
order not to take on the legal liability that comes with it. Avoiding risks, however, also means losing out on the
potential gain that accepting (retaining) the risk may have allowed. Not entering a business to avoid the risk of loss
also avoids the possibility of earning profits.

Risk Reduction

Risk reduction or optimization involves reducing the severity of the loss or the likelihood of the loss from occurring.
Optimizing risks means finding a balance between the negative risk and the benefit of the operation or activity; and
between risk reduction and effort applied. Outsourcing could be an example of risk reduction if the outsourcer can
demonstrate higher capability of managing or reducing risks.

Risk Sharing

Risk sharing means sharing with another party the burden of loss or the benefit of gain, from a risk, and the
measures to reduce a risk.

Risk Retention

Risk retention involves accepting the loss or the benefit of gain, from a risk when it occurs. Self- insurance falls in
this category. All risks that are not avoided are transferred or retained by default. Also, any amounts of potential loss
over the amount insured is retained risk. This is acceptable if the chance of a very large loss is small or if the cost to
insure for greater coverage involves a substantial amount that could hinder the goals of the organization.

Areas of Risk Management

As applied to corporate finance, risk management is the technique for measuring, monitoring and controlling the
financial or operational risk on a firm’s balance sheet.

The Base II framework breaks risks into market risk (price risk), credit risk and operational risk and also specifies
methods for calculating capital requirements for each of these components.

The most commonly encountered areas of risk management include:

1. Enterprise risk management
2. Risk management activities as applied to project management
3. Risk management for megaprojects
4. Risk management of information technology
5. Risk management techniques in petroleum and natural gas

The coverage of risk management in this book will however, be confined to management of risks associated with the
long- term investment in equity shares, bonds, and property and equipment.

INVESTMENT RISKS

Rational investors would agree that an investment’s required return should increase as the risk of the investment
increases. Most investors would also agree on how the expected rate of return should be calculated. But when the
discussion turns to risk, the debate begins.
Although a single risk premium must compensate the investor for all the uncertainty associated with the investment,
numerous factors may contribute to investment uncertainty. The factors usually considered with respect to
investments are business risk, financial risk, liquidity risk, default risk, interest rate risk, management risk, and
purchasing power risk.

BUSINESS RISK

Business risk refers to the uncertainty about the rate of return caused by the nature of the business. The most
frequently discussed causes of business risk are uncertainty about the firm’s sales and operating expenses. Clearly,
the firm’s sales are not guaranteed and will fluctuate as the economy fluctuates or the nature of the industry changes.
A firm’s income is also related to its operating expenses. If all operating expenses are variable, then sales volatility
will be passed directly to operating income. Most firms, however, have some fixed operating expenses (for example,
depreciation, rent, salaries). These fixed expenses cause the operating income to be more volatile than sales.
Business risk is related to sales volatility as well as to the operating leverage of the firm caused by fixed operating
expenses.

The degree of operating leverage at a particular sales level can be measured as:

(Sales- Variable Operating Costs)

(Sales- Variable Operating Costs- Fixed Operating Costs)

FINANCIAL RISK

The firm’s capital structure or sources of financing determine financial risk. If the firm is all equity financed, then
any variability in operating income is passed directly to net income on an equal percentage basis. If the firm is
partially financed by debt that requires fixed interest payments or by preferred stock that requires fixed preferred
dividend payments, then these fixed charges introduce financial leverage. This leverage causes net income to vary
more than the operating income. The introduction of financial leverage causes the firm’s lenders and its stockholders
to view their income streams as having additional uncertainty. As a result of financial leverage, both investment
groups would increase the risk premiums that they require for investing in the firm.

The degree of financial leverage at a particular level of operating income can be estimated as:

Operating Income
(Operating Income- Interest Expense- Before- tax equivalent of preferred dividends)

LIQUIDITY RISK

Liquidity Risk is associated with the uncertainty created by the inability to sell the investment quickly for cash. An
investor assume that the investment can be sold at the expected price when future consumption is planned. As the
investor considers the sale of the investment, he or she faces two uncertainties: (1) What price will be received? (2)
How long will it take to sell the asset? An example of an illiquid asset is a house in a market with an abundance of
homes relative to the number of potential buyers. This investment may not sell for several months or number of
potential buyers. This investment may not sell for several months or even years. Of course, if the price is reduced
sufficiently, the real estate will sell but the investor must make a selling price concession in order for the transaction
to occur.
In contrast, a government treasury bill can be sold almost immediately with very little concession on the selling
price. Such an investment can be converted to cash almost at will and for a price very close to the price the investor
expected.

The liquidity risk for ordinary equity shares is more complex. Because they are traded on organized and active
markets, ordinary equity shares can be sold quickly. Some ordinary equity shares, however, have greater liquidity
risk than others due to a thin market. A thin market occurs when there are relatively few shares outstanding and
investor trading interest is limited. The thin market results in a large price spread (the difference between the bid
price buyers are willing to pay and the ask price sellers are willing to accept). A large spread increases the cost of
trading to the investor and thus represents liquidity risk. Investors considering the purchase of illiquid investments--
ones that have no ready market or require price concessions—will demand a rate of return that compensates for the
liquidity risk.

DEFAUL RISK

Default risk is related to the probability that some or all of the initial investment will not be returned. The degree of
default risk is closely related to the financial condition of the company issuing the security and the security’s rank in
claims on assets in the event of default or bankruptcy. For example, if a bankruptcy occurs, creditors, including
bondholders have a claim on assets prior to the claim of ordinary equity shareholders.

INTEREST RATE RISK

Because money has time value, fluctuations in interest rates will cause the value of an investment to fluctuate also.
Although interest rate risk is most commonly associated with the bond price movements, rising interest rates cause
bond prices to decline and declining interest rates causes bond prices to rise. Movements in interest rates affect
almost all investment alternatives. For example, as a change in interest rates will impact the discount rate used to
estimate the present value of future cash dividends from ordinary shares. This change in the discount rate will
materially impact the analyst’s estimate of the value of a share of ordinary share.

MANAGEMENT RISK

Decisions made by a firm’s management and board of directors materially affect the risk faced by investors. Areas
affected by these decisions range from product innovation and production methods (business risk) and financing
(financial risk) to acquisitions. For example, acquisition or acquisition- defense decisions made by the management
of such firms materially affected the risk of the holders of their companies’ securities.

PURCHASING POWER RISK

Purchasing power risk is perhaps, more difficult to recognize than the other types of risk. It is easy to observe the
decline in the price of a stock or bond, but it is often more difficult to recognize than the purchasing power of the
return you have earned on an investment has declined (risen) as a result of inflation (deflation). It is important to
remember that an investor expects to be compensated for forgoing consumption today. If an individual is invested in
peso- denominated assets such real or inflation adjusted rate of return will be less than the nominal or stated rate of
return. Thus, inflation erodes the purchasing power of the peso and increases investor risk.

COMMONLY USED TECHNIQUES AND MODELS IN ASSESSING INVESTMENT ALTERNATIVES

UNDER RISK OR UNCERTAINTY

The following are the most commonly used techniques and models in assessing investment alternatives under risk or
uncertainty:

1. Probability
 2. Value of Information
3. Sensitivity Analysis
4. Simulation
5. Decision Tree
6. Standard Deviation and Coefficient of Variation
7. Project Beta

PROBABILITY

Decision Making under Certainty

Decision making under certainty means that for each decision action there is only one event and therefore only a
single outcome for each action. When an event is certain, there is a 100% chance of occurrence, hence the
probability is 1.0.

Decision Making under Uncertainty

Decision making under uncertainty, which is more common in reality, involves several events for each action with
its probability of occurrence. The decision maker may know the probability of occurrence of each of the events
because of mathematical proofs or the compilation of historical evidence. In the absence of these two bases, he may
resort to the subjective assignment of probabilities.

Management may know enough about the likelihood of each environment to attach probabilities of occurrence to
each alternative. If so, management certainly wants to select alternatives that appears to produce the largest outcome
as long as that alternative does not expose the company to a high probability of a large loss. The payoffs can be
reduced using each alternative to one figure by weighing the possible payoffs according to the relative probabilities
that the various conditions will occur.

Payoff is the value assigned to different outcome from a decision and may be positive or negative.

Briefly, information is deemed to meet the cost- benefit test if the expected value o f a decision (net of the costs of
information) increases as a result of obtaining additional information. The process in deciding whether the cost-
benefit criterion has been met is called information economics.

Assigning Probabilities

Because decisions makers normally deal with uncertainty, rather than certainty, they must estimate the probability of
various outcomes. It is necessary to assign probabilities that represent the likelihood of various events occurring. A
probability distribution describes the chance or likelihood of each of the collectively exhaustive and mutually
exclusive set of events. The probability distribution can be based on past data if management believes that the same
forces will continue to operate in the future. Probability provides a method for mathematically expressing doubt or
assurance about the occurrence of a chance event. The probability of an event varies from 0 to 1.

a. A probability of 0 means the event cannot occur, whereas a probability of 1 means the event is certain to
occur.
b. A probability between 0 and 1 indicates the likelihood of the event’s occurrence, e.g., the probability that a
fair coin will yield heads is 0.50 on any singe toss.

Basic Terms Used with Probability

 1. Two events are mutually exclusive if they cannot occur simultaneously (e.g., heads and tails cannot both
occur on a single toss of a coin).
2. The joint probability for two events is the probability that both will occur.
3. The conditional probability of two events is the probability that one will occur given that the other has
already occurred.
4. Two events are independent if the occurrence of one has no effect on the probability of the other (e.g.,
rolling two dice).
a. If one event has an effect on the other event, they are dependent.
b. Two events are independent if their joint probability equals the product of their individual
probabilities.
c. Two events are independent if the conditional probability of each event equals its unconditional
probability.

Illustrative Case 1.1 Decision Making under Uncertainty

M & O Corporation is considering two new designs for their kitchen utensils products- Product A and Product B.
Either can be produced using the present facilities. Each product requires an increase in annual fixed costs of Php
4,000,000. The products have the same selling price of Php 1,000 and the same variable costs per unit of Php 800.

After studying past experience with similar products, management has prepared the following probability
distribution:

Events Probability For

(Units Demanded) Product A Product B

5,000 0.0 0.1

10,000 0.1 0.1
20,000 0.2 0.1
30,000 0.4 0.2
40,000 0.2 0.4
50,000 0.1 0.1
1.0

Management would like to know

a. The break- even point for each product.

b. Which product should be chosen, assuming the objective is to maximize expected operating income?

Solution:

a. Since both products have the same contribution margin per unit of Php 200 (Php 1,000- Php 800),
breakeven point for each product will be the same computed as follows:

Breakeven point = Php 4,000,000/ Php 200

= 20,000 units

b. (1) Determine the expected demand for two products:

Event Product A Product B

Demand Probability Units Probability Units
5,000 0.0 0 0.1 500
10,000 0.1 1,000 0.1 1,000
 20,000 0.2 4,000 0.1 2,000
30,000 0.4 12,000 0.2 6,000
40,000 0.2 8,000 0.4 16,000
50,000 0.1 5,000 0.1 5,000
1.0 30,000 units 1.0 30,500 units

(2) Compute the expected operating income of the two products.

Product A Product B
Sales Php 30,000,000 Php 30,500,000
Variable Costs Php 24,000,000 Php 24,400,000
Contribution Margin Php 6,000,000 Php 6,100,000
Fixed Costs Php 4,000,000 Php 4,000,000
Operating Income Php 2,000,000 Php 2,100,000

Product B should be chosen because of the higher expected income compared with Product A.

PAYOFF (DECISION) TABLES

Payoff (decision) tables are helpful tools for identifying the best solution given several decision choices and future
conditions that involve risk.

A payoff table presents the outcomes (payoffs) of specific decisions when certain states of nature (events not within
the control of the decision maker) occur.

Example: A dealer in luxury yachts may order 0, 1, or 2 yachts for this season’s inventory. The cost of carrying each
excess yacht is Php 50,000, and the gain for each yacht sold is Php 200,000. The situation may be described by a
payoff table as follows:

State of Nature =
Season’s Actual Decision = Decision = Decision =
Demand Order 0 Order 1 Order 2

0 yachts 0 Php (50,000) Php (100,000)

1 yacht 0 Php 200,000 Php
150,000 2 yachts 0 Php 200,000 Php
400,000

The probabilities of the season’s demand are

Pr Demand
0.10 0
0.50 1
0.40 2

The dealer may calculate the expected value of each decision as follows:

Order 0 Order 1 Order 2

0.1 x 0 0.1 x Php (50,000) 0.1 x Php (100,000)
0.5 x 0 + 0.50 x Php 200,000 + 0.5 x Php 150,000
 0.4 x 0 + 0.40 x Php 200,000 + 0.4 x Php 400,000
EV (0) = 0 EV (1) = Php 175,000 EV (2) = Php 225,000\

The decision with the greatest expected value is to order two yachts, so, in the absence of additional information, the
dealer should order two.

EXPECTED VALUE OF PERFECT INFORMATION

In illustrative Case 1.1, even though the Php 210,000 expected value of operating income of the Product B is higher
than that of the Product A, management and/or owners may resist exposure to the percentage involved in making a
decision under risk. The probabilities associated with the demand for the products will actually occur are based on
existing information. The company may decide to hire marketing analysts to obtain additional information on the
environmental situation.

Perfect information is the knowledge that a future state of nature will occur with certainty, i.e., being sure of what
will occur in the future.

The expected value of perfect information (EVPI) is the difference between the expected value without perfect
information and the return if the best action is taken given perfect information.

The expected value of perfect information is the amount the company is willing to pay for the market analysts’
errorless advice. Assuming that the market analyst could indicate with certainty which condition would occur, a
manager would decide with complete certainty. Of course, “perfect information” is not perfect in the sense of
absolute predictions.

We can sometimes reduce the uncertainty involved in making a decision by collecting more information. However,
we will usually have to pay for this additional information. The value of perfect information tells us the maximum
amount it is worth paying for it. If we know in advance which one of the outcomes will occur, then we choose the
decision which will lead to the maximum payoff. This does not mean that we can control the choice of outcome. The
uncertainty about the future from taking a decision can sometimes be reduced by obtaining more information first
about what is likely to happen. Information can be obtained from various sources as the following:

1. Market research surveys;

2. Other surveys or questionnaire;
3. Conducting a pilot test; and
4. Building a prototype model.

Example (from the yacht dealer problem): If the yacht dealer were able to poll all potential customers and they
truthfully stated whether they would purchase a yacht this year (i.e., if perfect information about this year’s yacht
sales could be purchased), what is the greatest amount of money the dealer should pay for this information? What is
EVPI?

If the dealer had perfect knowledge of demand, he/she would make the best decision for each state of nature. The
cost of the other decisions is the conditional cost of making other than the best choice. This cost may be calculated
by subtracting the expected value form the expected value given perfect information. This difference measures how
much better off the decision maker would be with perfect information. From the payoff table, we find the expected
value of the best choice under each state of nature.

Best Action
Pr State of Nature Best Action Payoff Pr x Payoff
0.1 Demand = 0 Buy 0 Php 0 Php 0
0.5 Demand = 1 Buy 1 Php 200,000 Php 100,000
 0.4 Demand = 2 Buy 2 Php 400,000 Php 160,000
Php 260,000

The dealer expects to make Php 260,000 with perfect information about future demand, and the Php 225,000, if the
choice with the best expected value is made. The expected value of perfect information (EVPI) is then

Expected value with perfect information Php 260,000

Expected value of the best choice Php (225,000)

EVPI = Php 35,000

The dealer will not pay more than Php 35,000 for information about future demand because it would then be more
profitable to make the expected value choice than to pay more information.

Illustrative Case 1.2. Expected Value of Perfect Information

Adventure Corporation has three investment opportunities, each one yielding different profits depending on the state
of the market. The managing director has estimated that the probabilities of the three states occurring are as follows:

State Probability
I 0.5
II 0.2
III 0.3

The payoff table showing the incremental profits with each project is as follows:

Market State In (Php000’s)

I II III
Project A 75 20 5
Project B 45 80 55
Project C 35 60 90

Required:

1. Which project should be undertaken? Ignore risk and use the decision rule that the project with the highest
EV of profits should be taken.
2. What would be the value of perfect information about the state of the market? Would it be worth paying
Php 15,000 to obtain this information?

Solution:

1. EV of the profit each project

Project A Project B Project C

Market Probability Profit EV Profit EV Profit EV
State In (Php000’s)
I 0.5 75 37.5 45 22.5 35 17.5
II 0.2 20 4.0 80 16.0 60 12
III 0.3 5 1.5 55 16.5 90 27.0
EV of Profit 43.0 55.0 56.5
Analysis: Project C should be undertaken (ignoring risk) because it has the higher EV of profits.

2. With Perfect Information about the future state of the market, the company would choose the most
profitable project for the market state which the perfect information predicts will occur.

(i) If State I is forecast, Project A would be chosen: Php 75,000

(ii) If State II is forecast, Project B would be chosen: Php 80,000
(iii) If State III is forecast, Project C would be chosen: Php 90,000

EV of Profits if Perfect Information is given

Market Choose Profit Probability EV

State In (Php000’s) In (Php000’s)
I A 75 0.5 37.5
II B 80 0.2 16.0
III C 90 0.3 27.0
EV of Profits, with Perfect Information 80.5

Analysis: Since the EV of profits without information is Php 56,500 (choosing Project C), the value of perfect
information to the company is (Php 80,500- Php 56,500 = Php 24,000) and the cost of the information is Php
15,000, it would be worthwhile to obtain it.

SENSITIVITY ANALYSIS

Sensitivity analysis describes how sensitive the linear programming optimal solution is to a change in any one
number. Sensitivity analysis answers what- if questions about the effect of change in prices or variable costs;
changes in value; addition or deletion of constraints, such as available machine hours; and changes in industrial
coefficients, such as the labor- hours required in manufacturing in a specific unit.

After a problem has been formulated into any mathematical model, it may be subjected to sensitivity analysis. This
approach is especially useful and significant when probabilities of states of nature and decision payoffs are derived
subjectively rather than by using objectively quantifiable information.

A trial- and- error method may be adopted in which the sensitivity of the solution to changes in any given variable,
parameter, or other assumption is calculated.

1. The risk of the project being simulated may also be estimated.

2. The best project may be one that is least sensitive to changes in probabilistic (uncertain) inputs.
3. A sensitivity analysis may indicate whether expending additional resources to obtain better forecasts of
future conditions is cost justified.

In linear programming problems, sensitivity is the range within which a constraint value, such as a cost efficient or
any other variable, may be changed without changing the optimal solution. Shadow price is the synonym for
sensitivity in that context.

In the application of discounted cash flow methods (e.g;, net present value), a sensitivity analysis might be
performed to ascertain the effects of variability of the discount rate or periodic cash flows.

Financial planning models, including those for cash flows and capital budgeting, are other significant applications of
sensitivity analysis. For example, changes in selling prices or resource costs may affect available cash and require
more or less short- term borrowing.
Illustrative Case 1.3. Application of Sensitivity Analysis

Mirmo Company has prepared the following budgeted profitability statement for the current year operations:

Sales (2,500 units x Php 40) Php 100,000

Variable Cost
Materials Php 40,000
Labor Php 30,000 Php 70,000
Contribution Margin Php 30,000
Less: Fixed Cost Php 20,000
Profit Php 10,000

Required:
Make sensitivity analysis based on the above data.

Solution:

The changes in the sales revenue and costs on profit can be analyzed with the help of sensitivity analysis as follows:

1. If selling price is reduced by more than 10% budgeted, the company would incur loss.
2. If the sales are reduced by more than 10% of the budgeted sales of 2,500 units, the company would incur
loss.
3. If labor costs increase by more than 33.3% above the budgeted, the company would make a loss.
4. If material cost increases by 25% or more of the budgeted cost, the company would make a loss.
5. If the fixed costs increase by more than 50% of budgeted fixed cost, the company would incur loss.

If we observe the sensitivity of the above data, sales units and selling price per unit are more sensitive than the costs.
This vital information should be considered in making the final decision regarding policies on pricing and cost
control.

SIMULATION

Simulation is a technique for experimenting with logical and mathematical models using a computer. Despite the
power of mathematics, many problems cannot be solved by known analytical methods because of the behavior of
the variables and the complexity of their interactions, e.g.,

a. Corporate planning models

b. Financial planning models
c. New product marketing models
d. Queuing system simulations
e. Inventory control simulations

Experimentation is neither new nor uncommon in business. Building a mockup of a new automobile having one
department try out new accounting procedures, and test- marketing a new product are all forms of experimentation.
In effect, experimentation is organized trial and error using a model of the real world to obtain information prior to
full implementation.

Models can be classified as either physical or abstract.

 a. Physical models include automobile mockups, airplane models used for wind- tunnel tests, and breadboard
models of electronic circuits.
b. Abstract models may be pictorial (architectural plans), verbal (a proposed procedure), or logical-
mathematical. Experimentation with logical- mathematical models can involve many time- consuming
calculations. Computers have eliminated much if this costly drudgery and have led to the growing interest
in simulation for management.

The simulation procedure has five steps:

a. Define the objectives. The objectives serve as guidelines for all that follows. The objectives may be to aid
in the understanding of an existing system (e.g., an inventory system with rising costs) or to explore
alternatives (e.g., the effect of investments on the firm’s financial structure). A third type of objective is
estimating the behavior of some new system such as a production line. Thus, a simulation can be designed
to ask “what- if” questions, such as whether modifying the actual system will result in better performance.
b. Formulate the model. The variables to be included, their individual behavior, and their interrelationships
must be defined in precise logical- mathematical terms. The objectives of the simulation serve as guidelines
in deciding which factors are relevant. Moreover, inputs reflected in the model are of two kinds:
controllable and probabilistic. The former are those subject to the decision- makers’ influence, and the
latter involve circumstances beyond their control, such as general economic conditions or the acts of
competitors.
c. Validate the model. Some assurance is needed that the results of the experiment will be realistic. This
assurance requires validation of the model – often using historical data. If the model gives results
equivalent to what actually happened, the model is historically valid. Some risk remains, however, that
changes could make the model invalid for the future.
d. Design the experiment. Experimentation is sampling the operation of a system. For example, if a particular
policy is simulated on an inventory model for two years, the results are a single sample. With replication,
the sample size can be increased and the confidence level raised. The number of runs to be made, length of
each run, measurements to be made, and methods for analyzing the results are all part of the design of the
experiment. The experiments also may take the form of asking “what- if” questions, that is, varying an
input or assumption to ascertain the effect on the results.
e. Conduct the simulation- evaluation results. The simulation should be conducted with care. The results are
analyzed using appropriate statistical methods. These results constitute outcomes that permit evaluation of
the probabilities of real- world performance.

Advantages and Limitations of Simulation

The advantages of simulation are as follows:

a. Time can be compressed. A corporate planning model can show the results of a policy for 5 years into the
future, using only minutes of computer time.
b. Alternative policies can be explored. With simulations, managers can ask what- if questions to explore
possible policies, providing management with a powerful new planning tool.
c. Complex system can be analyzed. In many cases, simulation is the only possible quantitative method for
analyzing a complex system such as a production or inventory system, or the entire firm.

The limitations of simulation are as follows:

a. Cost. Simulation models can be costly to develop. They can be justified only if the information to be
obtained is worth more than the costs to develop the model and carry out the experiment.
b. Risk of error. A simulation results in a prediction of how an actual system would behave. As in forecasting,
the prediction may be in error.
Illustrative Case 1.4. Simulation Technique

The financial controller of Minitoons, Inc. has drawn the following projections with probability distributions:

Wages and Raw Sales

Salaries Materials Revenue
(Php000’s) Probability (Php000’s) Probability (Php000’s) Probability

10 - 12 0.3 6–8 0.2 30 – 34 0.1

12 – 14 0.5 8 – 10 0.3 34 – 38 0.3
14 – 16 0.2 10 - 12 0.3 38 – 42 0.4
12 – 14 0.2 42 – 46 0.6

You are required to simulate the cash flow projection and expected cash balance at the end of the sixth month. Use
the following random numbers.

Wages and salaries (Php000’s) 2 7 9 2 9 8

Raw materials (Php000’s) 4 4 1 0 3 4
Sales revenue (Php000’s) 0 6 6 7 0 2

Solution:

a. Simulation of Cash Flow Projection

Random Number Allocation

Wages and Salaries Raw Materials

Mid- Cumulative Random Mid- Cumulative Random

Point Probability Numbers Point Probability Numbers
(Php000’s) (Php000’s)
11 0.3 0–2 7 0.2 0–1
13 0.8 3–7 9 0.5 2–4
15 1.0 8–9 11 0.8 5–7
13 1.0 8–9

Mid- Cumulative Random

Point Probability Numbers

32 0.1 0
36 0.4 1–3
40 0.8 4–7
44 1.0 8–9

b. Expected Value Method of Cash Flow Projection

EV of salaries and wages = (11 x 0.3) + (13 x 0.5) + (15 x 0.2) = 12, 800
EV of raw materials = (7 x 0.2) + (9 x 0.3) + (11 x 0.3) + (13 x 0.2) = 10,000
EV of sales revenue = (32 x 0.1) + (36 x 0.3) + (40 x 0.3) + (44 x 0.2) = 34, 800
 Expected net cash inflow per month = 34,800 – 12,800 – 10,000 – 14,000 = Php 2,000
Expected cash balance after 6 months = 50,000 + (2,000 x 6) = Php 62,000

From the above table, the estimated cash balance at the end of sixth is Php 62,000.

DECISION TREE

Underlying Concept

A decision tree is an analytical tool used in a problem in which a series of decision has to be made at various time
intervals, with each decision influenced by the information that is available at the time it is made.

In its simplest form, a decision tree is a diagram that shows the several decisions or acts and the possible
consequences called the events of each act. In a more elaborate form, the probabilities and the revenue and costs of
each event’s outcome are estimated and these are combined to give an expected value for the event.

Decision trees provide a systematic framework for analyzing a sequence of interrelated decisions the managers may
make over time. Stemming from the present investment decisions are alternative scenarios that depend on the
occurrence of future events and consequences of those events. Decision tree analysis encourages the study and
understanding of these scenarios.

Advantages of Decision Tree Analysis

Some benefits that may be derived from the use of Decision Tree Analysis are:

1. Decision tree is an effective means of presenting the relevant information needed by management in an
investment problem. Such relevant information includes choices, risks, monetary gains, and objectives.
2. Combination of action choices with different events or results of action that chance or other uncontrollable
circumstances partially affect can be better presented and studied.
3. The interactions of the impact of future events, decisions alternatives, uncertain events and their possible
payoffs can be shown with greater ease and clarity.
4. Data are presented in a manner that enables systematic analysis and better decisions.

Limitations of Decision Tree Analysis

1. A decision tree does not give management the answers to an investment problem.
2. It does not identify all the possible events or does it list all the decisions that must be made on a subject
under analysis.
3. The interactions of such decision with the objective of other parts of the business organization would be too
complicated to compute manually. The use of computers will be suitable when studying the effect of
variation in figures and/ or the events involved.
4. Data are presented in a manner that enables systematic analysis and better decisions.

Steps in Making a Decision Tree

The requirements for the decision tree preparation are

1. Identification of the points and decisions and the alternatives available at each point.
2. Determination of the points of uncertainty and the type or range of alternative outcomes at each point.
3. Estimates of the probabilities of different events or results of actions.
4. Estimates of the costs and gains of various events and actions.
 5. Analysis of the alternative values in choosing a course of action.

Because the time between successive decision stages on a decision tree may be long, it would be more realistic to
consider the time value of future earnings and analyzing various investment alternatives.

Check the examples here:

1. https://www.youtube.com/watch?v=-f5I99Q9hwY
2. https://www.youtube.com/watch?v=fuBLLLPmUqg&list=TLPQMTIwNzIwMjAi57LaDl1-
vQ&index=2

Source: Financial Management – PRINCIPLES AND APPLICATIONS VOLUME 2 2015 EDITION

Author: Ma. Elenita Balatbat Cabrera BBA, MBA, CPA, CMA