In our last series of lessons, we learned a few forecasting techniques to help us estimate the future sales of a product. And it turns out, we can use those same tools to estimate costs too. We also mentioned that forecasting the future involves risk resulting from the uncertainty in our estimates and companies hate risk. There are ways we can mitigate the risk associated with our estimates, so, let's see what those look like. Up until now, and in fact for all the courses in the finance for Technical Manager specialization, we've made some very convenient assumptions that all the values. And our economic analyses have been accurate, that our estimates of the future are 100% correct. Can you estimate the future with certainty? Clearly no, therefore the next question becomes, what happens if your estimates are off? And even more importantly, how often they need to be before the decision to fund the project is affected? In this series of lessons, we'll discuss different risk management techniques, ways we account for those uncertain estimates. The first two will look at are scenario analysis and sensitivity analysis, then we'll explore one called decision tree analysis. Will wrap up with a decision making tool that accounts for factors other than financial ones. Because in reality, most decisions we make have many more factors to consider than just dollars and cents. Consider this example, which is one we did in the second course in the Finance for Technical Manager specialization. Based on your project proposal, your company plans to invest in a new metal 3D printing machine which is estimated to cost $100,000. You've done the analysis and you forecast after-tax cash flows or profits of $40,000 for the next 5 years. If your company has a discount rate of 16%,, what is the project's net present value and its internal rate of return, its NPV and IRR? Now, if this is the first course you're taking in the sequence, you may have no idea what I just mentioned. You can always take a look at Course number 2 to find out, or we can just say that NPV is the project's financial value to the company. And the IRR is its rate of return when taking time value of money into account using something we called a discounted cash flow analysis. The image is a screenshot of the spreadsheet we created, showing the initial investment of $100,000. The annual after-tax cash flows of $40,000, the time frame of 5 years, and the company's discount rate or hurdle rate of 16%. For the project to be a good investment, the NPV must be greater than zero and the IRR must be greater than the 16% discount rate. So, let's see how this project does. Rows 9 and 10 show the cash flows for each year, negative if they are payments, and positive if they are cash inflows. The next few rows shows the calculation to obtain the net present value and the internal rate of return. The comments next to the figures show you how we got there with Excel. What you can see is the project's net present value, it's NPV is well above 0 at $30,972. And the internal rate of return, the IRR, is well above the 16% discount rate showing an actual return of 29%. Bottom line, this project is a great investment for your company. You made estimates of the initial cost of the 3D printer and you went through a detailed analysis of its potential future benefits, captured in the after-tax cash flows from year 1 through year 5. The question we need to ask is this, if you're off on some of these estimates, then how does that affect the net present value and the internal rate of return? Let's see how we can handle that. An easy way to deal with such uncertainty and the financial risk associated with it is through a technique known as scenario analysis, the process is straightforward. You created what can be called the projects base case financial analysis, in essence, the values you believe are most likely to occur. Why most likely, because you've spent a lot of time figuring out what they should be, and these are the most realistic values you and your team has come up with. What you do now is bracket your base case analysis with one that represents the best case scenario. One that is highly optimistic, reflecting estimated values that could occur if everything went better than you expected. Of course, if your base case project is a winner, this scenario only makes it better yet if the question we want to answer is how much better? At the other end of the spectrum is the worst case scenario, which is the pessimistic case reflecting what the values could be if things are much worse than expected. This is probably the more important one as your bosses will want to know how bad things will get if they don't go according to plan. By building these two financial analyses around your base case, you can easily start to see how sensitive your project is to changes in your estimates. Here's a brief idea on how we perform a scenario analysis. The plan is to evaluate the project as a function of the different forecast scenarios using the metrics we've come to know and love, the NPV, the IRR as well as even the payback period. The base case you have in hand, what you and your team really think will happen are your estimates of the projects most likely future cash flows. You build the worst case scenario several possible ways, but the overall approach is to reduce the project's benefits. Perhaps with lower product sales resulting in lower revenues or with higher costs than you expected or maybe even a combination of both. You build the best case scenario in the same way just going in the other direction, higher revenues than expected, lower costs than expected or some combination of the two. Let's apply the concept here to our 3D printer and see what happens. Here is the new spreadsheet, which in Excel you get by just copying your base case worksheet and pasting it into a new worksheet and making a few changes to the data input section. For our best case scenario, we've reduced the initial investment by $10,000 to $90,000 and we increase the project's financial benefits. Its after tax cash flows by $5000. We don't need to be too optimistic here as we know things only get better from the base case. The new values are now reflected in the cash flows shown on row 10. The updated NPV and IRR are shown below and are now $57,343 and 41% respectively. As we said, it should be no surprise that the NPV and IRR are both higher. This was a good project to begin with and now it would be an even better investment. Okay, let's see what happens when we go in the other direction. Copy your base case worksheet once again and create a new worksheet called worst-case scenario. This time we've changed the initial investment to be more than expected by $10,000 to $110,000. And we've decreased the after tax cash flows by $10,000 to just $30,000 per year. Why do we make things more worse off than when we made them better? Because I find the worst-case scenario needs to be more pessimistic. If your estimates are way off, management will want to know the financial risks associated with that. They are less interested in how rosy things will be. In our example, our pessimistic forecast results in a negative NPV, never a good thing. And an internal rate of return of only 11% much lower than the discount rate of 16%. With a negative NPV and low IRR, the worst-case scenario produces a project that is a poor investment for the company. Will this kill the project? Maybe or maybe not. The question might be, what can you do to ensure the project doesn't go off the rails given this scenario? Here's a summary of the NPVs and IRRs for all three scenarios. The base case looks like a good project and would likely get funded if it fared well relative to other projects the company was funding. The best case scenario is obviously better and you're a hero if the results turn out this way. But on the other hand, if the project turned negative with the worst-case scenario, this is not a situation you want to be in. Your bosses will want to know why things are not going to plan and why your estimates were so far off. In either case, you're in the hot seat trying to explain your situation and that's never a fun career building opportunity. That's why you do these before you're in front of the executive office to see how far things need to go before the project goes negative. What do you do if your worst case scenario put your project in the red? The first thing you can do is to check and make sure if you are overly pessimistic, it's easy to create a lousy project just by being too conservative with your estimates. But if you think the values are in the realm of possibility, then you start thinking about what you can do to mitigate the risk of the worst-case scenario ever becoming a reality. Let's go back and see how we might create the best and worst case scenarios. The way to do it is to vary the inputs that determine the annual cash flows as we've seen. For the worst-case scenario relative to the base case, you might want to reduce the unit sold by 50% or so, which would really be a worst-case scenario. I actually had to do this recently for a project. I was working on upper management wanted the worst of the worst case scenarios And a 50% reduction in revenues was the way to do that. What happened? I had to adjust the operating costs to reflect this very low revenue value. The project was ultimately funded but only after the analysis was modified so it was financially acceptable when considering a much lower revenue than we had originally. Okay. Another way To create the worst case scenario is perhaps increase operating costs or even increased product costs by maybe 20%. We didn't have to go that far with our three d printer example for things to go bad but you might want to start there and just see what happens as we mentioned before. The best case doesn't have to be too rosy. Maybe increased sales by 10 or 20 or reduce costs By 10 or 20% and that should be just fine. Then you calculate the project's net present value and internal rate of return to see the impact of the best and worst case scenarios compared to the base case, then you'll be able to see how sensitive the estimates are. For factors such as units sold and operating costs. You'll be able to see how sensitive the estimates are for factors such as units sold and operating costs. Finally, what I recommend is to do a series of worst case scenarios to determine at what point the project goes into the red and is no longer financially worthwhile and if you feel that specific combination of variables is likely even remotely, then the next step is to create what is known as a risk mitigation plan to minimize the likelihood that the worst case scenario ever becomes a reality and there you have scenario analysis. So let's wrap this up with a few main takeaways. We make a lot of assumptions about the future cash flows in our financial analyses and scenario analysis allows us to bracket the uncertainty around these assumptions. Where our base case consists of estimates of what we believe is the most likely scenario. The best case is where we're rather optimistic and in my opinion, the more important worst case scenario is where things are much worse than expected. The reason we do this is so we can compare the best and worst case scenarios to our base case mainly to identify any red flags that might come up and if you do find red flags and what might be causing them, it's time to create an action plan to mitigate those risks and once again, your scenario should all be in the realm of possibility. So make sure you don't make your scenarios overly optimistic or overly pessimistic. You don't want your bosses getting too excited if things would go better than planned or perhaps even kill the project with a disastrous worst case scenario. Okay, one down and a few more to go in our next lesson, we'll discuss sensitivity analysis, what It is, how to conduct one and how to show the results to others. This is yet another fun spreadsheet exercise. So have excel handy so you can recreate what we're doing. I'm Michael Reedy and I'll see you next time.
