Category: Corporate Strategy
The Challenge
Whenever you take a decision where you can loose or gain something, value is at risk. Most decision makers want a situation where they maximize the value, and if everything goes wrong have a minimum of regret.
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Uncertainty – lack of information
Every item in a budget or a profit and loss account represents in principal a probability distribution. In this framework all items whether from the profit and loss account or from the balance sheet will have individual probability distributions.
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Risk – Exposure to Gain and Loss
It is when the decision involves consequences for the decision maker we faces a situation of risk. A traditional way of understanding risk is to calculate how much a certain event varies over time.
Decision – Criteria for choosing
The risk is best expressed by using a graph illustrating the probability curve. The slope tells us about the uncertainty involved, the steeper the curve the less uncertainty involved.
The advantages of simulation modelling
Businesses need the ability to assess what its future economic performance will be. Most organisations do this using a deterministic model, a model which does not consider the uncertainty inherent in all the inputs to the model.
Risk and Monte Carlo simulation
Risk, when does it occurs? Whenever the outcome of a situation is not 0 or 1 you have uncertainty or risk.
Risk, price and value
Having arrived at the probability distribution for the value of equity (see full story) we are able to calculate expected gain, loss and their probability when investing in a company where the capitalized value (price) is known.
Real options
In real life both for investment decisions and in valuation of companies there are managerial flexibility in the sense that at future points of time there is flexibility in choosing among alternatives.
