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Interest rates – Strategy @ Risk

Category: Interest rates

  • Uncertainty modeling

    Uncertainty modeling

    This entry is part 2 of 3 in the series What We Do

    Prediction is very difficult, especially about the future.
    Niels Bohr. Danish physicist (1885 – 1962)

    Strategy @ Risks models provide the possibility to study risk and uncertainties related to operational activities;  cost, prices, suppliers,  markets, sales channels etc. financial issues like; interest rates risk, exchange rates risks, translation risk , taxes etc., strategic issues like investments in new or existing activities, valuation and M&As’ etc and for a wide range of budgeting purposes.

    All economic activities have an inherent volatility that is an integrated part of its operations. This means that whatever you do some uncertainty will always remain.

    The aim is to estimate the economic impact that such critical uncertainty may have on corporate earnings at risk. This will add a third dimension – probability – to all forecasts, give new insight: the ability to deal with uncertainties in an informed way and thus benefits above ordinary spread-sheet exercises.

    The results from these analyzes can be presented in form of B/S and P&L looking at the coming one to five (short term) or five to fifteen years (long term); showing the impacts to e.g. equity value, company value, operating income etc. With the purpose of:

    • Improve predictability in operating earnings and its’ expected volatility
    • Improve budgeting processes, predicting budget deviations and its’ probabilities
    • Evaluate alternative strategic investment options at risk
    • Identify and benchmark investment portfolios and their uncertainty
    • Identify and benchmark individual business units’ risk profiles
    • Evaluate equity values and enterprise values and their uncertainty in M&A processes, etc.

    Methods

    To be able to add uncertainty to financial models, we also have to add more complexity. This complexity is inevitable, but in our case, it is desirable and it will be well managed inside our models.

    People say they want models that are simple, but what they really want is models with the necessary features – that are easy to use. If something is complex but well designed, it will be easy to use – and this holds for our models.

    Most companies have some sort of model describing the company’s operations. They are mostly used for budgeting, but in some cases also for forecasting cash flow and other important performance measures. Almost all are deterministic models based on expected or average values of input data; sales, cost, interest and currency rates etc.

    We know however that forecasts based on average values are on average wrong. In addition will deterministic models miss the important uncertainty dimension that gives both the different risks facing the company and the opportunities they bring forth.

    S@R has set out to create models that can give answers to both deterministic and stochastic questions, by linking dedicated Ebitda models to holistic balance simulation taking into account all important factors describing the company. The basis is a real balance simulation model – not a simple cash flow forecast model.

    Both the deterministic and stochastic balance simulation can be set about in two different alternatives:

    1. by a using a EBITDA model to describe the companies operations or
    2. by using coefficients of fabrications (e.g. kg flour pr 1000 bread etc.) as direct input to the balance model – the ‘short cut’ method.

    The first approach implies setting up a dedicated Ebitda subroutine to the balance model. This will give detailed answers to a broad range of questions about markets, capacity driven investments, operational performance and uncertainty, but entails a higher degree of effort from both the company and S@R. This is a tool for long term planning and strategy development.

    The second (‘the short cut’) uses coefficients of fabrications and their variations, and is a low effort (cost) alternative, usually using the internal accounting as basis. This will in many cases give a ‘good enough’ description of the company – its risks and opportunities. It can be based on existing investment and market plans.  The data needed for the company’s economic environment (taxes, interest rates etc) will be the same in both alternatives:

    The ‘short cut’ approach is especially suited for quick appraisals of M&A cases where time and data is limited and where one wishes to limit efforts in an initial stage. Later the data and assumptions can be augmented to much more sophisticated analysis within the same ‘short cut’ framework. In this way analysis can be successively built in the direction the previous studies suggested.

    This also makes it a good tool for short-term (3-5 years) analysis and even for budget assessment. Since it will use a limited number of variables – usually less than twenty – describing the operations, it is easy to maintain and operate. The variables describing financial strategy and the economic environment come in addition, but will be easy to obtain.

    Used in budgeting it will give the opportunity to evaluate budget targets, their probable deviation from expected result and the probable upside or down side given the budget target (Upside/downside ratio).

    Done this way analysis can be run for subsidiaries across countries translating the P&L and Balance to any currency for benchmarking, investment appraisals, risk and opportunity assessments etc. The final uncertainty distributions can then be “aggregated’ to show global risk for the mother company.

    An interesting feature is the models ability to start simulations with an empty opening balance. This can be used to assess divisions that do not have an independent balance since the model will call for equity/debt etc. based on a target ratio, according to the simulated production and sales and the necessary investments. Questions about further investment in divisions or product lines can be studied this way.

    Since all runs (500 to 1000) in the simulation produces a complete P&L and Balance the uncertainty curve (distribution) for any financial metric like ‘Yearly result’, ‘free cash flow’, economic profit’, ‘equity value’, ‘IRR’ or’ translation gain/loss’ etc. can be produced.

    In some cases we have used both approaches for the same client, using the last approach for smaller daughter companies with production structures differing from the main companies.
    The second approach can also be considered as an introduction and stepping stone to a more holistic Ebitda model.

    Time and effort

    The work load for the client is usually limited to a small team of people ( 1 to 3 persons) acting as project leaders and principal contacts, assuring that all necessary information, describing value and risks for the clients’ operations can be collected as basis for modeling and calculations. However the type of data will have to be agreed upon depending on the scope of analysis.

    Very often will key people from the controller group be adequate for this work and if they don’t have the direct knowledge they usually know who to ask. The work for this team, depending on the scope and choice of method (see above) can vary in effective time from a few days to a couple of weeks, but this can be stretched from three to four weeks to the same number of months.

    For S&R the time frame will depend on the availability of key personnel from the client and the availability of data. For the second alternative it can take from one to three weeks of normal work to three to six months for the first alternative for more complex models. The total time will also depend on the number of analysis that needs to be run and the type of reports that has to be delivered.

    S@R_ValueSim

    Selecting strategy

    Models like this are excellent for selection and assessment of strategies. Since we can find the probability distribution for equity value, changes in this brought by different strategies will form a basis for selection or adjustment of current strategy. Models including real option strategies are a natural extension of these simulation models:

    If there is a strategy with a curve to the right and under all other feasible strategies this will be the stochastic dominant one. If the curves crosses further calculations needs to be done before a stochastic dominant or preferable strategy can be found:

    Types of problems we aim to address:

    The effects of uncertainties on the P&L and Balance and the effects of the Boards strategies (market, hedging etc.) on future P&L and Balance sheets evaluating:

    • Market position and potential for growth
    • Effects of tax and capital cost
    • Strategies
    • Business units, country units or product lines –  capital allocation – compare risk, opportunity and expected profitability
    • Valuations, capital cost and debt requirements, individually and effect on company
    • The future cash-flow volatility of company and the individual BU’s
    • Investments, M&A actions, their individual value, necessary commitments and impact on company
    • Etc.

    The aim regardless of approach is to quantify not only the company’s single and aggregated risks, but also the potential, thus making the company capable to perform detailed planning and of executing earlier and more apt actions against uncertain factors.

    Used in budgeting, this will improve budget stability through higher insight in cost side risks and income-side potentials. This is achieved by an active budget-forecast process; the control-adjustment cycle will teach the company to better target realistic budgets – with better stability and increased company value as a result.

    This is most clearly seen when effort is put into correctly evaluating strategies-projects and investments effects on the enterprise. The best way to do this is by comparing and Choosing strategies by analyzing the individual strategies risks and potential – and select the alternative that is dominant (stochastic) given the company’s chosen risk-profile.

    A severe depression like that of 1920-1921 is outside the range of probability. –The Harvard Economic Society, 16 November 1929

  • WACC, Uncertainty and Infrastructure Regulation

    WACC, Uncertainty and Infrastructure Regulation

    This entry is part 2 of 2 in the series The Weighted Average Cost of Capital

     

    There is a growing consensus that the successful development of infrastructure – electricity, natural gas, telecommunications, water, and transportation – depends in no small part on the adoption of appropriate public policies and the effective implementation of these policies. Central to these policies is development of a regulatory apparatus that provides stability, protects consumers from the abuse of market power, guard’s consumers and operators against political opportunism, and provides incentives for service providers to operate efficiently and make the needed investments’ capital  (Jamison, & Berg, 2008, Overview).

    There are four primary approaches to regulating the overall price level – rate of return regulation (or cost of service), price cap regulation, revenue cap regulation, and benchmarking (or yardstick) regulation. Rate of return regulation adjusts overall price levels according to the operator’s accounting costs and cost of capital. In most cases, the regulator reviews the operator’s overall price level in response to a claim by the operator that the rate of return that it is receiving is less than its cost of capital, or in response to a suspicion of the regulator or claim by a consumer group that the actual rate of return is greater than the cost of capital (Jamison, & Berg, 2008, Price Level Regulation).

    We will in the following look at cost of service models (cost-based pricing); however some of the reasoning will also apply to the other approaches.  A number of different models exist:

    •    Long Run Average Total Cost – LRATC
    •    Long Run Incremental Cost – LRIC
    •    Long Run Marginal cost – LRMC
    •    Forward Looking Long Run Average Incremental Costs – FL-LRAIC
    •    Long Run Average Interconnection Costs – LRAIC
    •    Total Element Long Run Incremental Cost – TELRIC
    •    Total Service Long Run Incremental Cost – TSLRIC
    •    Etc.

    Where:
    Long run: The period over which all factors of production, including capital, are variable.
    Long Run Incremental Costs: The incremental costs that would arise in the long run with a defined increment to demand.
    Marginal cost: The increase in the forward-looking cost of a firm caused by an increase in its output of one unit.
    Long Run Average Interconnection Costs: The term used by the European Commission to describe LRIC with the increment defined as the total service.

    We will not discuss the merits and use of the individual methods only direct the attention on the fact that an essential ingredient in all methods is their treatment of capital and the calculation of capital cost – Wacc.

    Calculating Wacc a World without Uncertainty

    Calculating Wacc for the current year is a straight forward task, we know for certain the interest (risk free rate and credit risk premium) and tax rates, the budget values for debt and equity, the market premium and the company’s beta etc.

    There is however a small snag, should we use the book value of Equity or should we calculate the market value of Equity and use this in the Wacc calculations? The last approach is the recommended one (Copeland, Koller, & Murrin, 1994, p248-250), but this implies a company valuation with calculation of Wacc for every year in the forecast period. The difference between the two approaches can be large – it is only when book value equals market value for every year in the future that they will give the same Wacc.

    In the example below market value of equity is lower than book value hence market value Wacc is lower than book value Wacc. Since this company have a low and declining ROIC the value of equity is decreasing and hence also the Wacc.

    Wacc-and-Wacc-weights

    Calculating Wacc for a specific company for a number of years into the future ((For some telecom cases, up to 50 years.)) is not a straight forward task. Wacc is no longer a single value, but a time series with values varying from year to year.

    Using the average value of Wacc can quickly lead you astray. Using an average in e.g. an LRIC model for telecommunications regulation, to determine the price paid by competitors for services provided by an operator with significant market power (incumbent) will in the first years give a too low price and in the later years a to high price when the series is decreasing and vice versa. So the use of an average value for Wacc can either add to the incumbent’s problems or give him a windfall income.

    The same applies for the use of book value equity vs. market value equity. If for the incumbent the market value of equity is lower than the book value, the price paid by the competitors when book value Wacc is used will be to high and the incumbent will have a windfall gain and vise versa.

    Some advocates the use of a target capital structure (Copeland, Koller, & Murrin, 1994, p250) to avoid the computational difficulties (solving implicit equations) of using market value weights in the Wacc calculation. But in real life it can be very difficult to reach and maintain a fixed structure. And it does not solve the problems with market value of equity deviating from book value.

    Calculating Wacc a World with Uncertainty

    The future values for most, if not all variable will in the real world be highly uncertain – in the long run even the tax rates will vary.

    The ‘long run’ aspect of the methods therefore implies an ex-ante (before the fact) treatment of a number of variable; inflation, interest and tax rates, demand, investments etc. that have to be treated as stochastic variable.
    This is underlined by the fact that more and more central banks is presenting their forecasts of macro economic variable as density tables/charts (e.g. Federal Reserve Bank of Philadelphia, 2009) or as fan charts (Nakamura, & Shinichiro, 2008) like below from the Swedish Central Bank (Sveriges Riksbank, 2009):

    Riksbank_dec09

    Fan charts like this visualises the region of uncertainty or the possible yearly event space for central variable. These variables will also be important exogenous variables in any corporate valuation as value or cost drivers. Add to this all other variables that have to be taken into account to describe the corporate operation.

    Now, for every possible outcome of any of these variables we will have a different value of the company and is equity and hence it’s Wacc. So we will not have one time series of Wacc, but a large number of different time series all equally probable. Actually the probability of having a single series forecasted correctly is approximately zero.

    Then there is the question about how long it is feasible to forecast macro variables without having to use just the unconditional mean (Galbraith, John W. and Tkacz). In the charts above the ‘content horizon’ is set to approximately 30 month, in other the horizon can be 40 month or more (Adolfson, Andersson, Linde, Villani, & Vredin, 2007).

    As is evident from the charts the fan width is increasing as we lengthen the horizon. This is an effect from the forecast methods as the band of forecast uncertainty increases as we go farther and farther into the future.

    The future nominal values of GDP, costs, etc. will show even greater variation since these values will be dependent on the growth rates path’s to that point in time.

    Mont Carlo Simulation

    A possible solution to the problems discussed above is to use Monte Carlo techniques to forecast the company’s equity value distribution – coupled with market value weights calculation to forecast the corresponding yearly Wacc distributions:

    Wacc-2012

    This is the approach we have implemented in our models – it will not give a single value for Wacc but its distribution.  If you need a single value, the mean or mode from the yearly distributions is better than using the Wacc found from using average values of the exogenous variable – cf. Jensen’s inequality (Savage & Danziger, 2009).

    References

    Adolfson, A., Andersson, M.K., Linde, J., Villani, M., & Vredin, A. (2007). Modern forecasting models in action: improving macroeconomic analyses at central banks. International Journal of Central Banking, (December), 111-144.

    Copeland, T., Koller, T., & Murrin, J. (1994). Valuation. New York: Wiley.

    Copenhag Eneconomics. (2007, February 02). Cost of capital for broadcasting transmission . Retrieved from http://www.pts.se/upload/Documents/SE/WACCforBroadcasting.pdf

    Federal Reserve Bank of Philadelphia, Initials. (2009, November 16). Fourth quarter 2009 survey of professional forecasters. Retrieved from http://www.phil.frb.org/research-and-data/real-time-center/survey-of-professional-forecasters/2009/survq409.cfm

    Galbraith, John W. and Tkacz, Greg, Forecast Content and Content Horizons for Some Important Macroeconomic Time Series. Canadian Journal of Economics, Vol. 40, No. 3, pp. 935-953, August 2007. Available at SSRN: http://ssrn.com/abstract=1001798 or doi:10.1111/j.1365-2966.2007.00437.x

    Jamison, Mark A., & Berg, Sanford V. (2008, August 15). Annotated reading list for a body of knowledge on infrastructure regulation (Developed for the World Bank). Retrieved from http://www.regulationbodyofknowledge.org/

    Nakamura, K., & Shinichiro, N. (2008). The Uncertainty of the economic outlook and central banks’ communications. Bank of Japan Review, (June 2008), Retrieved from http://www.boj.or.jp/en/type/ronbun/rev/data/rev08e01.pdf

    Savage, L., S., & Danziger, J. (2009). The Flaw of Averages. New York: Wiley.

    Sveriges Riksbank, . (2009). The Economic outlook and inflation prospects. Monetary Policy Report, (October), p7. Retrieved from http://www.riksbank.com/upload/Dokument_riksbank/Kat_publicerat/Rapporter/2009/mpr_3_09oct.pdf