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the Sources of Value approach.

Finally, it is worth noting that I did not carry out any value calculations as part of this

analysis. It is only worthwhile doing value calculations when the time value of money is

an important factor. There are many financial decisions where time and capital are not the

key variables. This is an example of one such situation.

6. Rank the following risks in order of importance to a major corporation.

a. An uncertainty of Â±$10m on sales revenue.

b. A 10% chance that a pump will break down and lower sales in the pipeline division by

$10m.

c. A 0.1% chance of a rupture in a pipeline that would cost $1bn to clean up should it

happen.

d. A one third chance that the legal staff will win a lawsuit against a competitor for breach

of copyright and gain a payout of $200m.

e. A one-in-ten chance that the legal staff will lose a separate case and a fine of $500m will

be imposed.

f. A 5% chance that a customer will default on a $1m payment.

I will first review the risks then place them in order of importance.

Item A is what I term a plus or minus risk. Because it is symmetrical the impact times

probability calculation shows a zero impact.

Item B has a risk impact of 10% of $10m or $1m.

Item C has the same risk impact but the absolute magnitude of the impact is such that

it would need to be considered separately as it could cause financial distress. I will assume

that $1bn is sufficient to cause even a â€˜majorâ€™ corporation financial distress.

598 Individual work assignments: Suggested answers

Item D is a risk impact of plus $66.7m while item E has a risk impact of minus $50m.

With item E it would be important to check the companyâ€™s ability to take a hit of $500m

should the case go against the company. I will assume that the company can just cope

because it is said to be â€˜majorâ€™.

The impact of F is just $50,000.

A simple ranking of the risk impacts gives the order:

D, E, B, C, F and A. (with B and C ranked third equal).

However, the list needs to be overviewed to allow for possible financial distress

effects. This would move item C to the top of the list and item E to second. So the order

would be:

C, E, D, B, F, A.

7. Now consider the same risks from the perspective of: (a) a small startup company engaged

in just this one business activity; and (b) a medium-sized company engaged in several lines

of business with an overall market value of $500m.

The startup company could probably find that the $10m downside on sales revenue caused

it financial distress. This would mean ranking items A and B equally. Item C has a huge

downside but would so clearly wipe out the company that it would tend to ignore it as

it suffered from many other downside risks that were much more likely to wipe it out.

Item D could represent a huge gain in relation to the scale of a startup company. With

an expected value of $66.7m I would expect this to be the companyâ€™s largest asset. Item E

would be a real concern since if the case was lost, the company would be bankrupt even if

it won the law case in item D. Item F is small.

So my ranking for the startup company is:

D, E, A, B, C and F.

The medium-sized company is closer to the major corporation except that the $500m

loss would probably be too big for it to cope with. Since this hit has a much greater prob-

ability than the pipeline rupture it would go to the top of my risk list for this company.

My order is therefore:

E, C, D, B, F and A.

Again I have to stress that there are a number of subjective judgements made in my

answers to this question. Risk is not a topic where there are always answers which are

unequivocal.

8. You are in charge of the evaluation of a research project. The route to market for the research

can be characterised as having six steps. Step 1 is research. Step 2 is safety evaluation. Step

3 is pilot plant scale evaluation. Step 4 concerns gaining the relevant government permits

while Step 5 involves obtaining board sanction. The final step is to sell the product. If the

project fails at any stage the financial outcome is nil. Build a simple decision tree model that

will allow you to investigate the following variables for each stage: probability of success;

cost of progressing through this stage; length of this stage; and finally value of a research

success that makes it to market successfully. Then use the model to test the viability of the

following proposal given a 10% CoC and assuming that money is all spent at the end of the

relevant period.

599 Building block 5: Risk

Stage Cost/benefit Duration Success rate

1. Research $4m 1 year 50%

2. Safety $4m 1 year 85%

3. Pilot $10m 1 year 75%

4. Permits $10m 2 years 50%

5. Sanction $1m 0.5 year 95%

6. Sales Construction cost $50m. Overall Construction time 90%

value $1bn when sales start. 1 year

The model will show seven possible outcomes. There are six different ways of failing and

just one way to succeed. Each stage will have its own discount factor and will add further

costs. My model is as follows:

Probabilities

Disc Factor Fail now Continue Cost/Ben PV Risked PV

Stage 1 0.909 50.0% 50.0% âˆ’4 âˆ’3.6 âˆ’1.8

Stage 2 0.826 7.5% 42.5% âˆ’8 âˆ’6.6 âˆ’0.5

Stage 3 0.751 10.6% 31.9% âˆ’18 âˆ’13.5 âˆ’1.4

Stage 4 0.621 15.9% 15.9% âˆ’28 âˆ’17.4 âˆ’2.8

Stage 5 0.592 0.8% 15.1% âˆ’29 âˆ’17.2 âˆ’0.1

Stage 6 0.538 1.5% 13.6% âˆ’79 âˆ’42.5 âˆ’0.6

Prize 0.538 13.6% 921 495.7 67.5

check 100.0%

NPV 60.2

The discount factors are calculated as at the end of the periods. Stage 4 is long but stage

5 is short. The discount factor for the prize is the same as the factor for the construction

spend.

The fail now column shows what percentage of the total fail at each stage. So 50% fail

at the first stage and 50% continue. Since 15% of those projects that make it to the second

stage fail at this time the overall â€˜fail nowâ€™ percentage for stage 2 is 15% of 50% equals 7.5%.

Hence 42.5% make it through stage 2, and so on. The check calculation confirms that the

sum of the fail-now percentages and the probability of winning the prize is equal to 100%.

The costs gradually increase as the project progresses. So to fail after stage 1 only implies

a cost of $4m while failing after the plant has been built results in a cost of $79m. Each cost

is multiplied by the discount factor to reach a present value.

The final stage is to calculate the expected value. This requires that each outcome is

multiplied by its probability. The expected value is the sum of all of these numbers. The

answer, given all of the assumptions, is $60m. This suggests that the project is viable as

long as the assumptions are reasonable expected value estimates and the company is big

enough to take the risks.

600 Individual work assignments: Suggested answers

The model can also be used to test the impact of the various failure rate assumptions.

The project is robust (i.e. continues to show a positive NPV) to very large changes in the

failure rate for stage 1. Even a 90% failure rate, for example, still gives an NPV of $9m.

This is because the costs incurred up to the end of stage 1 are low. The prize could also be

reduced significantly while still retaining a positive NPV.

9. Use your judgement to place the following risks in the categories of 1â€“5 on a diversifiability

scale where 1 means fully diversifiable risks while 5 means no diversification benefit.

Building damaged by a tornado. I would assume this was fully diversifiable, i.e. 1 on my

scale.

Costs rise owing to inflation. This is a classic undiversifiable risk because it hits all

companies in the same way. So it is 5 on the scale.

Costs rise owing to failure of new computer system. This is largely unique to the com-

pany concerned but may have some costs in common with other companies so I would

rate it as 1 or 2.

Cost over-run on new factory owing to strikes delaying construction. Strikes can be

unique to a company but are often also felt by many companies at the same time. So this

is probably a 2 or 3.

Shop sales rise owing to demand for very popular childrenâ€™s toy. The particular toy is

unique but ours is not the only toy shop. So I would rank this as 3.

Loss of a legal case for copyright infringement. This is presumably unique to the com-

pany concerned so the ranking is 1: fully diversifiable.

Computer systems need replacing owing to technology changes. This tends to be a

generic problem and so would rank as a 4 or a 5.

Production equipment for a specialised product needs replacement owing to technology

changes. Technology changes impact on many companies but this is described as a spe-

cialised product so this is about a 3 on my scale.

10. Describe possible mechanisms that might cause some degree of correlation between the

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