Including Monte Carlo simulation in a corporate finance valuation can be very helpful for decision makers to better understand the project's risk and the key risk drivers. In order to achieve the aim of greater decision-clarity, it is imperative that not only all relevant risks are included in the analysis, but also that any relevant relationships (correlations) are properly included in the model.
The following example give an illustration of the importance of considering risks in a financial analysis, and also shows that taking into account 'systematic risk' such as timing, is key to understanding the full risk. The risk in timing of events can often affect many factors, and therefore are often a causal factor for related different costs or revenues. For example:
- The (late) timing of a product launch often goes together with higher development costs, later start of profits, and if the product is launched in a competitive field possibly lower product pricing or lower market share;
- When building a new facility, the (late) timing of the facility starting to produce product may mean higher start-up costs, possibly missed sales, and
- Valuation of large CAPEX projects (such as building a pipeline) in which the project schedule can drive CAPEX, future cash flows and with a late schedule even result in penalties.
The following models illustrate how the risk around the timing of a future product launch can be incorporated in a financial analysis:
The file has three sheets:
- NoRisk, which shows the valuation of a product launch, but ignores any of the risks;
- WithRisk, which shows the valuation of a product launch, but does take into account eight different potential risk drivers;
- WithRiskOnTiming, which shows the valuation with the same general assumptions as those in situation #2, but now takes into account that the driver behind the risk in pricing and market share is that it is currently still unknown when the product can/will be launched.
The 'base inputs' for all three sheet (and NPV's) are the same, with development and market research expenses in 2019 and 2020, and an expected product launch in 2021.
In the NoRisk sheet, the 10-year NPV for the product launch is based on the 'base inputs', and calculated to be $10.4M.
As shown in the WithRisk sheet, when taking into account the various risk around expenses, market share, pricing, COGS, and marketing expenses, the following results are obtained:
|eNPV||P (NPV < 0)||Low NPV||High NPV|
While the NPV based on all the 'base values' was $12.5M, the average of all the NPVs in the simulation (the eNPV) is only $7.9M. Also, the results show that there is a 10% probability that the NPV will be negative. The key risk drivers of the NPV are shown in the Tornado chart below.
The risk around the price ($75 - $120/unit) and peak market share (20% - 40%) drive the majority of the risk.
In the WithRiskOnTiming sheet, the same risks (and approximately the same ranges) that were included on the WithRisk sheet are considered, but the model also takes into account that an underlying factor for the uncertainty in the price and market share is that it is uncertain when the product launch will occur. In order to take this uncertainty of launch-timing into account, the following enhancements were made to the model:
- The product launch date is included as a risk (range between Nov 2020 and Jan 2022);
- The product development/R&D and the market research expenses are specified per year, so that a change in the schedule will result in lower or higher expenses;
- Using the envelop method to correlate variables, the peak market share and the product pricing are linked to the launch date. An earlier launch date is expected to result in a higher peak market share and higher pricing, while a later launch date is expected to results in a lower share and price.
The results from this analysis show the following:
|eNPV||P (NPV < 0)||Low NPV||High NPV|
Taking into account relationships in a model can however have a considerable influence on a model's results. Including this launch timing risk, the eNPV decreased to only $117K and there is a greater than 50% probability that the NPV will be negative. It also now becomes clear that the key risk driver is actually the launch timing, as seen in the Tornado chart below.
In summary, taking into account risk can considerable change our view of the value and attractiveness of potential projects. Taking into account relationships within a project, such as the risk around timing of events, is also critical. For decision-makers evaluating this potential project, the insight from the analysis that includes all risks as well as the launch timing risk, can considerable change the discussion and decisions around approval or potential risk mitigation of the project.