Other Scenarios In this section, we use Excel’s Scenario tool to perform “What If?” analysis and evaluate the net present
Other Scenarios In this section, we use Excel’s Scenario tool to perform “What If?” analysis and evaluate the net present
values, rates of return, and break-even points under conditions other than the most probable. Specifically, we might ask what the financial payoffs might be under the worst combination of conditions that might reasonably occur, or under the best combination of conditions that might reasonably occur. The answers to such queries can provide additional help for a company’s financial officers to decide whether or not to proceed with a project.
Capital Budgeting: Risk Analysis with Scenarios ❧ 449 Table14-1
Scenario Conditions Scenario
Total Annual Market, sets
Investment
Unit Variable Cost, $/set
$1.60 MostProbable
Table 14-1 shows values for the total annual market, the facility investment, and the unit variable cost under what we describe as the best-on-best, most probable, and worst-on-worst conditions. For the best-on-best conditions, we assume that (1) the total annual market is the forecast value of 180,000 units plus twice the standard forecast error of 18,000, which gives a total of 216,000 units; (2) the investment is the lowest value of $86,000; and (3) the unit variable cost is the lowest value of $1.60/set.
The most probable conditions in Table 14-1 are those we have already analyzed. For the best-on-best conditions, we assume that (1) the total annual market is the forecast value of 180,000 units plus twice the standard forecast error of 18,000, which gives a total of 216,000 units; (2) the investment is the lowest value of $86,000; and (3) the unit variable cost is the lowest value of $1.60/set. For the worst-on-worst conditions, we assume that (1) the total annual market is the forecast value of 180,000 units minus twice the standard forecast error of 18,000, which gives a total of 144,000 units; (2) the investment is the high- est value of $98,000; and (3) the unit variable cost is the highest value of $2.35/set. It is highly unlikely that all three factors would simultaneously be at the best or worst values, so the results should bracket the range of possible outcomes the company might face.
Before using Excel’s Scenario Manager tool, test the worksheet to see that all output cells are linked to the cells that will be allowed to vary. To do this, change the value in an input cell and check to see that other cells that should be linked to the input cell change as expected. Excel’s auditing tool (described in Chapter 1) can also be used to verify cell linkages. Failure to ensure that all cells are cor- rectly linked is the most common cause for errors in using Excel’s Scenario tool.
To use Excel’s Scenario tool, be sure the spreadsheet solution for the most probable scenario is open. Next, click on the Tools menu and select Scenario. This will display the Scenario Manager dialog box shown in Figure 14-9.
Click the Add button to display the dialog box shown in Figure 14-10. In the “Add Scenario” dialog box of Figure 14-10, enter “Best-on-Best” for the name of the scenario
and enter C18,B23,C24 for the cells that are to change. (These cells have the current values for total annual market, investment, and unit variable cost.) Click on the OK button or press Enter to go to the “Scenario Values” dialog box of Figure 14-11. Enter the values for the best total annual market (216,000 in Cell C18), best investment ($86,000 in Cell B23), and best unit variable cost ($1.60/set in Cell C24).
Click the OK button to return to the “Add Scenario” dialog box (Figure 14-10) and add the second scenario (Most Probable). Note that the changing cells will be the same as for the best-on-best scenario,
450 ❧ Corporate Financial Analysis with Microsoft Excel ® Figure14-9
Scenario Manager Dialog Box
Figure14-10
Dialog Box for Adding the Best-on-Best Scenario
Figure14-11
“Scenario Values” Dialog Box with Values for the Changing Cells for the Best-on-Best Scenario
Capital Budgeting: Risk Analysis with Scenarios ❧ 451 although their values will be different (i.e., 180,000, $92,000, and $2.15). Click the OK button or press
Enter to return to the “Scenario Values” dialog box. The values for the changing cells will be the same as on the current worksheet, which will be the most probable values unless they have been changed. (You can, if you wish, omit adding the Most Probable scenario from the scenario analysis because it simply reproduces the current values.)
Repeat the steps to add the worst-on-worst scenario. Enter the conditions from Table 14-1 for the worst-on-worst scenario in the same manner. After all three scenarios have been entered, return to the “Scenario Manager” dialog box, which will appear as Figure 14-12.
Click the “Summary” button to obtain the “Scenario Summary” dialog box, Figure 14-13. Enter the cell identities for the result cells (G33:G35 for the NPV, IRR, and MIRR values at the end
of five years and B36 for the break-even point). Click the OK button or press Enter to obtain the scenario summary shown in Figure 14-14. This will appear on a new worksheet titled “Scenario Summary.”
Edit the scenario summary of Figure 14-14 to provide the finished scenario summary shown in Figure 14-15. Replace the column and row numbers for the variables in Cells C6:C8 and C10:C14 of
Figure14-12
“Scenario Manager” Dialog Box with All Three Scenarios Entered
Figure14-13
Scenario Summary Dialog Box with Result Cells Identified
452 ❧ ® Corporate Financial Analysis with Microsoft Excel Figure14-14
Scenario Summary with Results (Unedited)
2 Scenario Summary
3 Current Values: Best-on-Best Most Probable Worst-on-Worst
5 Changing Cells:
9 Result Cells:
14 Notes: Current Values column represents values of changing cells at 15 time Scenario Summary Report was created. Changing cells for each 16 scenario are highlighted in gray.
Figure 14-14 with the names of the variables, as in Figure 14-15. You can make other changes, such as deleting the note, editing the titles and centering them, centering column titles and values, and so forth, to produce a finished scenario summary, as shown in Figure 14-15. The goal is to provide the results of the scenario analysis in a management-oriented presentation. Make sure that what is essential is included, and delete what is not needed.
Note that under the worst-on-worst conditions, the investment will fail to break even at the end of five years.
Figure14-15
Scenario Summary after Editing and Formatting
1 SCENARIO SUMMARY FOR ALADDIN GAMES 2 Wholesale Price = $4.66/set and Market Share = 15.81%
3 Best-on-Best
Most Probable
Worst-on-Worst
5 Changing Variables
6 Total Annual Market, sets
7 Investment, dollars
8 Unit Variable Cost, $/set
9 Results at End of 5 Years
10 Net Present Value
11 Internal Rate of Return
12 Modified Internal Rate of Return
13 Time for Investment’s Breaking Even during the 5-Year Analysis Period 14 Break-Even Point, years
2.62 4.95 Failed
Capital Budgeting: Risk Analysis with Scenarios ❧ 453 One should also recognize that the results shown in Figure 14-15 are for a selling price of $4.66/set
and a market share of 15.81 percent. These are the optimum values for the most probable conditions. Because the company does not know the future actual conditions beforehand, it is reasonable for the purpose of the analysis to set the selling price for the most probable conditions. The decision to be made at the point of analysis is whether or not to make and market the new product. Once that decision is implemented and as better cost and market data become available, the price can be adjusted to what is best for whatever conditions prevail.
Locking a Scenario The output of the Scenario Manager can be locked to prevent output values from changing. To lock
(or unlock) the Scenario Manager tool, go to the Scenario Manager dialog box, click on the “Edit” box to open the “Edit Scenario” dialog box, and then check (or uncheck) the “Prevent Changes” box.
Students’ Comments on Excel’s Scenario Manager One of my jobs is long-term financial planning … and we do a lot of risk analysis based on certain scenarios.
… It is too bad our [corporate] software doesn’t have the scenario analysis capabilities that Excel does because it would make our lives much easier. Many times we have to “put the hammer” to our [corporate] software to try to model an unusual situation.
The Scenario Manager tool is a handy one to help organize a range of scenarios or “What if?” cases. For my job, it would be cases of portfolio position (long, short) against very high or very low commodity prices.
Scenario analysis is a very handy tool. In the home finance industry, it could be most useful in comparing the potential downside with the most probable to see if the risks are manageable and if they are outweighed by the likely reward. For example, a decision to refinance using an adjustable-rate mortgage vs. a fixed-rate mort- gage could be weighed by looking at the worst case future rate scenario compared to the most likely scenario.
The scenario manager provides a really efficient way to change different variables and to see the results. … I could see using this in real estate financing and other investment decisions. … I think this tool can make an
investment decision much easier to understand and I can see how useful it could be in presentations.
Learning about the scenario manager tool for the first time was kind of like obtaining a new secret weapon for battling your enemies. Once armed with this knowledge, one can easily perform scenarios for all types of business situations from rolling out a new product to making a new capital investment. Providing this infor- mation will give both the optimists and conservatives a certain level of comfort in knowing what direction the project can take from one end to the other.