Okay, I hope you're still with me after that last lesson which had a lot of deep financial concepts embodied in it. In this lesson, we're going to look at how the capital budget should be presented to decision makers. All this financial theory is well in good but frankly, most financial people don't understand it. So how can we expect non financial managers and executives to make decisions based on what we've discussed so far, telling a decision maker that an opportunity should be pursued because it has a positive NPV really is an injustice to the whole process. What is missing from this kind of presentation is a bigger picture perspective of the size of the opportunity of the impact that it's going to have on the income statement and the balance sheet, and very importantly, the risk associated with the opportunity. I can't underscore the importance of looking at the opportunity from a multi dimensional financial position.

The decision package should also include a suite of financial metrics beyond just NPV, IRR, payback and and profitability index that we discussed in our previous lesson. Also consider including things like gross profit margin, even emerging operating margin return on capital employed, which I like because it eliminates financial leverage, return on equity, which incorporates leverage and the debt to equity ratio. If you are incrementally leveraging your balance sheet by pursuing this opportunity. Now the decision maker has context which he or she can compare this opportunity against existing lines of business or other competing opportunities. Finally, let's tackle this question of risk. Let's return to those p 10s, p 50.

And p 90s. That we documented a way back during our due diligence. We can now use these ranges to stress tests. Our capital budgeting model. Let's start with what is called a tornado chart. A tornado chart simply takes the capital budgeting model, and runs it by changing one variable at a time between the P 10.

And the P 90 assumptions to determine the full range of potential outcomes driven by one assumption. It's much like a sensitivity analysis. However, the difference being in a sensitivity analysis, we typically take each assumption and vary it by some arbitrary number, say 10% to determine which assumptions are the most sensitive, because our due diligence has explored the fringes of possibility, we have a much more fulsome understanding of risk. When you finish doing this for all of your assumptions. You get an insightful chart with all of your major uncertainties. This facilitates a conversation about risk management If say a $50 oil price syncs the project, then perhaps you can buy some protection in the form of a derivative hedging instrument to cut off that undesirable tail of the investment opportunity.

The second thing you can do with these ranges is to run what is called a Monte Carlo analysis. A Monte Carlo analysis allows you to simulate making the same investment decision over and over and over again, you can simulate this by making this decision, say 100,000 times and then see the results plotted on a graph. So let's look at the graph and then describe how it came to be. On our Y axis we have probability and on our x axis, we have our net present value, the graph plus an S curve, and you read the S curve by lining up the points on the curve with the two axes. So at a zero MPV, it appears that there is a 79 Point 5% chance that the outcome will be higher than zero based on the 2000 simulated trials of making this decision. The total range of potential outcomes is between minus 34 and positive 115.

Note where the NPV breaks even and evaluate whether this is a tolerable risk for the decision maker. Consider that there is a 20% chance that you could destroy shareholder value by pursuing this capital investment opportunity. Do you do it? I guess it comes down to a personal or corporate level of risk tolerance. At least now you have a numerical representation of risk, which for some facilitates a much deeper discussion of the capital budgeting opportunity. These askers are also interesting because they can be interpreted based on the business plan and the different opportunities long flat S curve indicates a higher risk opportunity because the variation of return spans a huge range.

Alternatively, a tall narrow S curve indicates an opportunity with less volatility and less uncertainty. Let's return to our idea of maintaining a portfolio of opportunities, we can now start plotting all these s curves on the same chart, you now have a much more visual sense of each of the competing investment opportunities. Getting back to how these s curves are created is beyond the scope of this course. But I want to give you just a glimpse into how it works and perhaps enough that you can play around with the idea and the tool on your own if this is of interest. The way the Monte Carlo simulation works is that it spins each of the assumptions based on the range of possible outcomes that we determined during due diligence. The p 10 p 50.

The 90 represent points along the distribution curve. for argument's sake, let's just say this looks like a normal distribution. In other words, the proverbial bell curve as depicted on the screen. What this means is that points closer to the P 10. And the P 90 should have a lower probability of occurring, then points closer to the P 50 assumption. For simplicity sake, I'm going to divide up this normal distribution into three parts around our P 10, p 50, and P 90 assumptions and attribute a 25% probability to each of the P 10 and P 90 values and a 50% probability to the P 50 assumption.

It turns out that for decision making, which is an imprecise science at best, this simplification of a normal distribution does not materially impact the quality of the decision package. So what the Excel model will do is that it will use the probabilities we've attributed to each assumption and run the capital budgeting model over and over again, half the time, the P 50. For any given assumption will be selected 25% of the time, it could be either the P 10, or the pinata assumption. Let's just tie this back to where we started our discussion earlier using our influence diagram. What I'm saying is that every uncertainty we identified will now have a distribution curve associated with it. We use the NPV as our definition of shareholder value.

This becomes what we call the forecast target in our probabilistic analysis. Once you have your assumptions and your forecast identified, you run software that allows you to pick how many iterations you want to do or to run the model and it will spit out your S curve and your tornado chart. This type of analysis provides a visual right representation of the risk and reward trade offs that are being made associated with each of the capital investment opportunities. Now, one piece of software that you might use to do this types of analysis is called crystal ball, which is now an Oracle product and you can download a 15 day free trial. If you want to give it a try by following the links on the screen. It works as an ad in tech sell, and with a little guidance is remarkably easy to use.

Let's wrap up our discussion by summarizing three important points regarding how we should communicate and facilitate the presentation of the capital budgeting decision. First, make sure you give the decision makers a full sum perspective of the opportunity by including various operating and financial metrics, be sure to include an indication of what impact the opportunity will have on both the income statement as well as the balance sheet. Secondly, we talked about ways to graphically represent risk and sensitivity using a tornado chart. This helps to facilitate a conversation about risk management. And third, Monte Carlo simulations help us appreciate the risk we are taking by making this capital investment. It's better to know before the capital expenditures are made, then to find out a few years from now, when the returns failed to pan out.

In our next lesson, we're going to tackle a related but separate analysis which deals with the financing aspect of a capital investment opportunity. Till then