Base Case and Sensitivity Analysis – “Waterfall and Tornadoes”
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Transcript of Base Case and Sensitivity Analysis – “Waterfall and Tornadoes”
Base Case and Sensitivity Analysis – “Waterfall and Tornadoes”
22.05-I • Deterministic & Sensitivity Analysis
We create a model to evaluate alternatives and test the importance of uncertainties.
Strategy Table
DecisionStructure
DeterministicAnalysis
ProbabilisticAnalysis
AppraisalInitial
Situation
Iteration
InfluenceDiagram
1
2
3
4
5
DeterministicModelA B C
DeterministicSensitivity
DecisionTree
ProbabilityDistributions
Value ofInformation
Decision Quality
32.05-I • Deterministic & Sensitivity Analysis
We will discuss using spreadsheets for deterministic (base case) analysis and sensitivity analysis.
• Base Case Analysis and Waterfall Diagrams
• Sensitivity Analysis and Tornado Diagrams
• Using Sensitivity Results for Insight
42.05-I • Deterministic & Sensitivity Analysis
Base case* analysis gives an initial comparison of each alternative.
1
2
3
4
5
A B C
Spread
sheet
Model
Base CaseInputs
¥
1 2 3 4
Base CaseOutput
s
The important question is “Why is #3 best?”
* All variables set at their “base case” values
52.05-I • Deterministic & Sensitivity Analysis
Another base case output—the cash flow plot—illustrates cash needs and yields from each alternative under consideration.
–60
–50
–40
–30
–20
–10
0
10
20
30
1 2 3 4 5 6 7 8 9 10
Year
AnnualCash Flow ($ millions)
Run Out
Moderate Investment
Aggressive Investment
The plot shows how moderate or aggressive investment extends mature product life, with economic break-even in 3–5 years.
62.05-I • Deterministic & Sensitivity Analysis
Initial evaluation with the model also yields important insights into sources of value and risk.
1
2
3
4
5
A B C
Spread
sheet
Model
Base Case
Waterfall of Value
Sources of Value
Uncertainty Range
TornadoDiagram
Sources of Risk
72.05-I • Deterministic & Sensitivity Analysis
Base case evaluation shows the net value of each alternative, in this case dealing with mature products investment alternatives.
Net Present Value($ millions)
50 100 150 2000 300250
“Run Out” 71
ModerateInvestment
291
AggressiveInvestment
280
Why is the value of the aggressive investment less than the moderate investment?
82.05-I • Deterministic & Sensitivity Analysis
This horizontal “waterfall chart” shows incremental sources of value and cost for each strategy.
Net Present Value ($ millions)
0 200 400 600 800 1,000
71
291
280
Run Out
ModerateInvestment
AggressiveInvestment
Halo Revenues
Product Revenues
Key
Added Value
Promotion
SF
Reduced Value
Product Revenues
Halo Revenues
SFPr.
Although typically drawn vertically, this orientation simplifies labeling.
92.05-I • Deterministic & Sensitivity Analysis
The waterfall chart can “break out” the base case value added or lost from each major source.
Required Investment
Net Present Value
Market Growth
New Products
Fixed Costs
Value from FutureSale
Base Case NPV
Business context: Purchase an existing business, add value, then sell.
Current Contributi
on
Contributions
to Profit
0
102.05-I • Deterministic & Sensitivity Analysis
The elements of a waterfall correspond to the “value centers” of the influence diagram.
Licensing
Licensing
Contribution
Licensing
Revenues
Commission
Costs
Service
Consulting
Revenues
Service
Contribution
Installation
Costs
FixedOverhead
Fixed
Overhead
Base Case NPV
It’s best to “sketch” the waterfall in parallel with developing the influence diagram.
Required Investmen
t
Net Present Value
NPV
Waterfall of Value
Corresponding Influence Diagram0
112.05-I • Deterministic & Sensitivity Analysis
The choice of “value centers” depends on the business context and the strategic decisions.
Retail chain
• Existing stores
• New locations
Biotech product company
• Product #1
• Product #2
• Upcoming product launch
• Research pipeline
Global expansion opportunity• North American contribution• Europe• Asia/Pacific• Other regions
Business portfolio• Business unit, group, or sector #1• Business unit, group, or sector #2
Think of value centers as primary market segments or business centers or components of value, not cost centers.
122.05-I • Deterministic & Sensitivity Analysis
The waterfall is a good way to reconcile changes in a strategy’s valuation over time.
InitialValuation
Data Revisions
Revised Valuation May 27
Revised Valuation June 15
Competitor Exits
Increase Fixed
Overhead
0
NetPresentValue
132.05-I • Deterministic & Sensitivity Analysis
Create the waterfall by working “backwards,” incrementally turning off sources of value.
Contributions to Profit
NPV
Base Case Value
1
Value from Future Sale
2Overhead
3
Product C
4
Product B
4
Product A
Step 1 Record base case NPV.Step 2 Change future sales value to zero; record
NPV.Step 3 Set fixed and overhead costs to zero;
record NPV.Step 4 Switch off product contributions one by
one; record each NPV.Step 5 With all products switched off, NPV should
equal the required investment.
5
Required Investmen
t
0
142.05-I • Deterministic & Sensitivity Analysis
One note about style: use short phrases on a “vertical bar” waterfall.
Short
sometimes.phrases
cantell
a
powerful
story
NetPresentValue
You might be tempted to rotate text to add more words.
0
152.05-I • Deterministic & Sensitivity Analysis
Vertical text is OK in books and handouts, but it’s not effective in presentations.
unless lying down!
your
audience happens
to
be
Sideways text is not
effective,
162.05-I • Deterministic & Sensitivity Analysis
The horizontal waterfall format accommodates many bars and lots of text.
Net Present Value
Look at all arrows & neat stuff you can write on
this waterfall chart now that it’s oriented the “other” way.
You run the risk of boring your audience of course,
but if you write like Charles Dickens, you might
consider this form of waterfall.
You can also write in the arrow, or use text to help
emphasize direction: Left!
Right!
And your audience doesn’t have to lie down!
In here!
172.05-I • Deterministic & Sensitivity Analysis
The waterfall shows only base case values—it is equally important to understand which factors drive value higher or lower.
RequiredInvestmen
t
Contributions to ProfitValue from
FutureSale
Base Case Value
NPV
Product A
Product B
Product C
Overhead
Uncertainties that Increase Value
Uncertainties that Decrease Value
0
182.05-I • Deterministic & Sensitivity Analysis
We will discuss using spreadsheets for deterministic (base case) analysis and sensitivity analysis.
• Base Case Analysis and Waterfall Diagrams
• Sensitivity Analysis and Tornado Diagrams
• Using Sensitivity Results for Insight
192.05-I • Deterministic & Sensitivity Analysis
What do analysts in companies typically do when they encounter uncertainties?
• Ignore them
• Run three cases: base case, best case, worst case− How good is “best?”
− How bad is “worst?”
• Make an “assumption” and proceed.− The “easy way out”
− Are these justified?
A “tornado” analysis provides the justification you need for leaving variables at their base values versus including their uncertainty explicitly in your analysis.
202.05-I • Deterministic & Sensitivity Analysis
Sensitivity (“tornado”) analysis identifies the primary sources of risk, which are then analyzed using probabilistic analysis.
DecisionStructure
DeterministicAnalysis
ProbabilisticAnalysis
Appraisal
Iteration
Many Uncertainti
es
Tornado
Primary Sources of
Risk
Initial Situation
We also typically reassess ranges for the top bars in the tornado.
212.05-I • Deterministic & Sensitivity Analysis
Single-variable sensitivity analysis determines the change in model output when one input changes.
Spreadsheet Model
NPV ($ MM) 75
OUTPUT43
44
Low Case8%
-6
High Case28%
134
Swing140
Market Share 20%
INPUT Base Case
A B
1
2
222.05-I • Deterministic & Sensitivity Analysis
A “tornado diagram” graphically depicts the variables’ contributions to uncertainty in NPV.
Net Present Value ($ millions)
-50 0 50 100 150 200
Base Value = 75
Price per dose
Market Share
Doses per Day
Prevalence Rate
Compliance
Treatment Rate
Development Cost
COGS (%Rev)
Uptake curve lengthAnnual Price change
$1.50 $6.00
8% 28%
1 3
1.5% 3.0%
30.0% 70.0%
30.0% 60.0%
140.0 60.0
30% 15%
7 3
-2% 1%
232.05-I • Deterministic & Sensitivity Analysis
The tornado diagram is generated by reevaluating NPV using low and high values for each variable separately.
Base Case NPV = $75 MM
Variable
Variable Values
Base10% Low
90% High
Price per Dose $3.50 $1.50 $6.00
Market Share 20% 8% 28%
Doses per Day 2 1 3
Prevalence Rate 2.0% 1.5% 3.0%
Compliance 55% 30% 70%
Treatment Rate 50% 30% 60%
Development Cost 100 60 140
COGS 25% 15% 30%
Uptake curve length 5 3 7
Annual Price Change 0% -2% 1%
Results
“Low” “High” Swing
-2 171 173
-6 134 140
7 142 135
41 142 101
14 112 98
22 101 79
99 51 48
100 62 37
91 56 35
55 86 31
242.05-I • Deterministic & Sensitivity Analysis
Uncertain inputs can have a large effect on the output for two reasons.
The input may be highly uncertain.
Range of Input
Range of Output
Range of Input
The output variable may be highly sensitive to small changes in an input.
Range of Output{
252.05-I • Deterministic & Sensitivity Analysis
Three of the variables are “coupled” or “dependent.” They tend to vary together.
• We should determine the sensitivity of NPV to joint changes in these variables.
• Note: These scenarios are obtained by assessing a combination of events that would lead to a low (10th percentile) and a high (90th percentile) outlook.
“Once a day”
1
70%
$6.00
“bid”*
2
55%
$3.50
“tid”*
3
30%
$1.50
Number of Doses
Compliance
Price per Dose
Price/Dosing Scenario
*tid: ter in die – three times a day
bid: bis in die – twice a day
262.05-I • Deterministic & Sensitivity Analysis
Joint sensitivity analysis determines the sensitivity of NPV to simultaneous changes in coupled* variables
Variable Values
Variable
Doses per Day
Compliance
Price per Dose
Low
3
30%
$ 1.50
BaseCase
High
2
55%
$ 3.50
1
70%
$ 6.00
Base Case NPV = $75 MM
Results
“Low” “High” Swing
- 13 87 100
* Coupled, or dependent, uncertainties are likely to vary together—either positively or negatively correlated.
272.05-I • Deterministic & Sensitivity Analysis
The updated tornado diagram focuses our attention on the most significant sources of risk.
Net Present Value ($ millions)
-50 0 50 100 150 200
Base Value = 75
Market Share 8% 28%
Prevalence Rate 1.5% 3.0%
Treatment Rate 30.0% 60.0%
Development Cost 140.0 60.0
COGS (%Rev) 30% 15%
Uptake curve length 7 3
Annual Price change -2% 1%
TID BIDDose/Pricing Scenario
Sensitive
Insensitive
We suggest re-assessing the uncertainty in the most sensitive uncertain variables and including them in probabilistic analysis.
282.05-I • Deterministic & Sensitivity Analysis
Uncertainties with the greatest “swing” are crucial to capturing the uncertainty in overall value.
*The uncertainty in the model output (e.g., NPV) is proportional to the sum of the squares of individual input variable swings, if the variables are independent.
31Price Change
TOTAL
35Uptake Curve
37COGS
48Dev Costs
79Treatment Rate
100Dose/Pricing Scen
101Prevalence Rate
140Market Share
Individual Swing
Uncertainty
961
50526
1225
1369
2304
6241
10000
10201
18225
Variance (swing)2
100%2%
98%2%
96%3%
93%4%
89%12%
77%19%
58%20%
38%38%
Cumulative Contribution
Contribution to Total
Uncertainty*
292.05-I • Deterministic & Sensitivity Analysis
We will discuss using spreadsheets for deterministic (base case) analysis and sensitivity analysis.
• Base Case Analysis and Waterfall Diagrams
• Sensitivity Analysis and Tornado Diagrams
• Using Sensitivity Results for Insight
302.05-I • Deterministic & Sensitivity Analysis
The tornado diagram helps identify potential problems with the assessments and the model.
Net Present Value
Are these really the most sensitive, or are the ranges too wide?
Too symmetric? Are experts biased?
Low cost, high NPV!
Cost:
High Low
“Floating” bar—are the values
right?Are these really low/zero swings, or is there a mistake?
Does the base case match the waterfall (and spreadsheet) base
case?
312.05-I • Deterministic & Sensitivity Analysis
Waterfall and tornado analyses provide tools to “mine” for NPV insights.
• Which risk factors might we be able to control?
• Is any strategy clearly most attractive?- How can we revise the strategy to capture more value?- How can we help focus the attention of company management?
• Where should the analysis be refined?
• What are the primary sources of value?
• What drives the uncertainty in net present value?
• What uncertainties have the greatest effect on decisions?
• Which variables are dependent?
332.05-I • Deterministic & Sensitivity Analysis
Appendix
342.05-I • Deterministic & Sensitivity Analysis
There is another form of sensitivity—decision sensitivity; it identifies uncertainties that affect decision-making.
How important is each uncertainty—enough to change our decision?
Example: A Drug Development investment decision
Invest
Don’t Invest$ 0
Market Share
Uncertainties
PrevalencePrice/dosingscenario
352.05-I • Deterministic & Sensitivity Analysis
The tornado identifies uncertainties that affect our choice between investing or not; this is called “decision sensitivity.”
Variable
Net Present Value
Base Value: 75
Don’t Invest
Invest
Invest
Don’t Invest
Invest Invest
Invest Invest
Invest Invest
Best Decision, Given:
Low Input High Input
We could change our decision based on the outcome Market Share and Dose/Pricing Scenario alone. These two are “decision sensitive.”
0 50 100 150
Market Share
Prevalence Rate
Treatment Rate
Development Cost
COGS (%Rev)
Dose/Pricing Scan
8% 28%
1.5% 3.0%
30.0% 60.0%
140 60
30% 15%
TID BID
362.05-I • Deterministic & Sensitivity Analysis
Judge the quality of available information before plunging into evaluation.
4Clear
Values andTrade-offs
5LogicallyCorrectReasoning
6Commitmentto Action
0% 100%
Decision
Quality
1Appropriate
Frame
2
Creative,
Doable
Alternatives
3Meaningful, Reliable
Information
3Meaningful, Reliable
Information
Meaningful, Reliable Information:
0% “Blissful ignorance”• Don’t know how much we know• Ignoring uncertainty• Ignoring “intangibles”
50% “Informed about uncertainty”• Know information gaps• Know what’s important• Quantified uncertainty• Interdependence not explored
100% “Knowledgeable and ready” • Information correct and explicit• Important gaps filled• Know limits of knowledge