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December 2010 – Strategy @ Risk

Strategy @ Risk

Month: December 2010

  • Planning under Uncertainty

    Planning under Uncertainty

    This entry is part 3 of 6 in the series Balance simulation

     

    ‘Would you tell me, please, which way I ought to go from here?’ (asked Alice)
    ‘That depends a good deal on where you want to get to,’ said the Cat.
    ‘I don’t much care where—‘said Alice.
    ‘Then it doesn’t matter which way you go,’ said the Cat.
    –    Lewis Carroll, Alice’s Adventures in Wonderland

    Let’s say that the board have sketched a future desired state (value of equity) of the company and that you are left to find if it is possible to get there and if so – the road to take. The first part implies to find out if the desired state belongs to a set of feasible future states to your company. If it does you will need a road map to get there, if it does not you will have to find out what additional means you will need to get there and if it is possible to acquire those.

    The current state (equity value of) your company is in itself uncertain since it depends on future sales, costs and profit – variable that usually are highly uncertain. The desired future state is even more so since you need to find strategies (roads) that can take you there and of those the one best suited to the situation. The ‘best strategies’ will be those that with highest probability and lowest costs will give you the desired state that is, that has the desired state or a better one as a very probable outcome:

    Each of the ‘best strategies’ will have many different combinations of values for the variables –that describe the company – that can give the desired state(s). Using Monte Carlo simulations this means that a few, some or many of the thousands of runs – or realizations of future states-will give equity value outcomes that fulfill the required state. What we need then is to find how each of these has come about – the transition – and select the most promising ones.

    The S@R balance simulation model has the ability to make intermediate stops when the desired state(s) has been reached giving the opportunity to take out complete reports describing the state(s) and how it was reached and by what path of transitional states.

    The flip side of this is that we can use the same model and the same assumptions to take out similar reports on how undesirable states were reached – and their path of transitional states. This set of reports will clearly describe the risks underlying the strategy and how and when they might occur.

    The dominant strategy will then be the one that has the desired state or a better one as a very probable outcome and that have at the same time the least probability of highly undesirable outcomes (the stochastic dominant strategy):

    Mulling over possible target- or scenario analysis; calculating backwards the value of each variable required to meet the target is a waste of time since both the environment is stochastic and a number of different paths (time-lines) can lead to the desired state:

    And even if you could do the calculations, what would the probabilities be?

    Carroll, L., (2010). Alice‘s Adventures in Wonderland -Original Version. City: Cosimo Classics.

  • Working Capital and the Balance Sheet

    Working Capital and the Balance Sheet

    This entry is part 2 of 3 in the series Working Capital

     

    The conservation-of-value principle says that it doesn’t matter how you slice the financial pie with financial engineering, share repurchases, or acquisitions; only improving cash flows will create value. (Dobbs, Huyett & Koller, 2010).

    The above, taken from “The CEO’s guide to corporate finance” will be our starting point and Occam’s razor the tool to simplify the balance sheet using the concept of working- and operating capital.

    To get a better grasp of the firm’s real activities we will as well separate non-operating assets from operating assets – since it will be the last that defines the firm’s operations.

    To find the amount of operating current assets we have to deduct the sum of minimum cash level, inventories and account receivables from total current assets. The difference between total- and operating current assets is assumed placed in excess marketable securities – and will not be included in the working capital.

    Many firms have cash levels above and well beyond what is really needed as working capital, tying up capital that could have had better uses generating higher return than mere short-term placements.

    The net working capital now found by deducting non-interest bearing current liabilities from operating current assets, will be the actual amount of working capital needed to safely run the firms operations – no more and no less.

    By summing net property, plant and equipment and other operating fixed assets we find the total amount of fixed assets involved in the firm’s operations. This together with net working capital forms the firms operating assets, assets that will generate the cash flow and return on equity that the owners are expecting.

    The non-operating part – excess marketable securities and non-operating investments – should be kept as small as possible, since this at best only will give an average market return. The rest of the above calculations give us the firm’s total liability and equity, which we will use to set up the firm’s ordinary balance sheet:

    However, by introducing operating-, non-operating- and working capital we can get a clearer picture of the firm’s activities ((Used in yearly reports by Stora Enso, a large international Pulp & Paper company, noted on NASDAQ OMX in Stockholm and Helsinki.)):

    The balance sheet’s bottom line has been reduced by the smallest value of operating current assets and non-interest bearing debt and the difference between them – the working capital – will be an asset or a liability depending on which of them that have the largest value:

    The above calculations is an integral part of our balance simulation model and the report that can be produced for planning, strategy- and risk assessment from the simulation can be viewed her; report for the most likely outcome (Pdf, pp 32). However this report can be produced for every run in the simulation giving the opportunity to look at tail events that might arise, distorting expectations.

    Simplicity is the ultimate sophistication. — Leonardo da Vinci

    References

    Dobbs, D, Huyett, H, & Koller, T. (2010). The ceo’s guide to corporate finance. McKinsey Quarterly, 4. Retrieved from http://www.mckinseyquarterly.com/home.aspx

    Endnotes