PART
4. Interpret the results
7.2 USING SCENARIO ANALYSIS WITH EXCEL’S SCENARIO MANAGER
There are several tools which can be used to create scenarios in Excel. Scenario Manager is one of them and it is located on the Excel ribbon’s Data tab under What If analysis. Through the sample model of the previous chapter we will describe the use of Excel’s Scenario Manager.
You may recall that Exhibit 6.1 presented the forecast cash flows of a project based on a con-stant growth rate from year 2 onwards. Moreover, given a base case discount rate it presented the Net Present Value (NPV) of the project. Recall also that by varying the growth rate and the discount rate we constructed 2-dimensional sensitivity analysis tables. What we have ignored in this sample model is inflation. When appraising capital projects using discounted cash flow tech-niques such as NPV we should take account of inflation. Inflation is a general increase in prices leading to a general decline in the real value of money. In times of inflation, the project appraiser should take into account both the real return for the initial cash outflow (i.e. the required return of the project if there were no inflation in the economy) and an additional return to compensate for inflation. The overall required return is called the money or nominal rate of return and is linked to the real rate of return by the following equation (known as the Fisher equation):
(1 + i) = (1 + r) × (1 + π) where
i: money (nominal) rate r: real rate
π: inflation rate
or as an approximation:
i ≈ r + π
So, to take into consideration inflation when calculating NPV we must adjust the discount rate r (assumed here to be equal to the real rate) by adding to it the inflation rate π.
Thus, our simple model now has 3 input variables: growth rate, discount rate, and in flation rate (Exhibit 7.1).
Please note that the base case NPV of the project is now lower than the −€39 value prior to inflation. This was expected since we increased the discount rate by the inflation rate. Gen-erally speaking, the higher the discount rate the higher the risk of a project and the lower its net present value is. Let us now build 3 scenarios concerning the NPV of the project (assum-ing the cash inflows are presented in nominal terms) based on 3 different values of the input variables for each scenario:
As you have probably noticed, the values for the growth rate and the discount rate for the 3 scenarios are the same as those we used in the sensitivity analysis in Chapter 6. For example, recall that the range for the growth rate varied between 3% and 8% whereas the range for the discount rate varied between 7% and 12%. Whereas the worst case for the growth rate is definitely the lower value, the opposite holds true for the discount rate. Regarding the in flation rate, we used Forbes’3 2.1% (see the article by Forbes: “Economic Assumptions for your 2014 Business Plan”) as the base case. We then adjusted the base case arbitrarily by 0.5% to come to the best case and worst case scenarios respectively (Exhibit 7.2). It is time now to create the first Excel scenario.
On the Excel ribbon’s Data tab we click What If Analysis, and then choose Scenario Manager (Exhibit 7.3a). In the Scenario Manager we click the Add button and then we type a name for the scenario, e.g. base case (Exhibit 7.3b). By clicking on the red arrow on the right of the Changing Cells box an empty box appears. We then select the cells B1:B3 on the active worksheet. We click the Comment box and type Base Case just to remember what this scen-ario is all about. The comment is optional. Finally, by pressing the OK button the Scenscen-ario Values dialog box opens, with a box for each changing cell (Exhibit 7.4).
The values presented at Exhibit 7.4 are the values currently on the worksheet so we do not need to change them. Finally, by pressing the OK button we return to the Scenario Manager.
7.2.1 Adding 2 More Scenarios
Provided that the above scenario is our base case we need to create 2 more scenarios; the worst case and the best case. To do so we open the Scenario Manager again and click the EXHIBIT 7.1 Simple NPV project appraisal model with 3 input variables
EXHIBIT 7.2 Worst, base, and best case scenarios input variables Worst Case Base Case Best Case
Growth rate (g) 3.0% 5.0% 8.0%
Discount rate (r) 12.0% 10.0% 7.0%
Inflation rate (π) 2.6% 2.1% 1.6%
Add button. The Scenario name is now “worst case” but the Changing cells remain the same: B1:B3. Then the Scenario Values dialog box opens, with a box for each changing cell. Now we need to change the B1 cell box manually to 3% (growth rate under the worst case scenario), the B2 cell box to 12% (discount rate under the worst case scenario), and the B3 cell box to 2.6% (inflation rate under the worst case scenario). Then by pressing the OK button we return to the Scenario Manager. Similarly we add another scenario, the best case
EXHIBIT 7.3 Adding a scenario to Excel’s Scenario Manager (a)
(b)
EXHIBIT 7.4 Setting the values to each input variable of the scenario
one, where in the Scenario Values dialog box we enter the values of 8% to the B1 cell box (growth rate under the best case scenario), 7% to the B2 cell box (discount rate under the best case scenario), and 1.6% to the B3 cell box (inflation rate under the best case scenario) and then press OK. Now the Scenario Manager should look like the one in Exhibit 7.5. We see at the bottom of the Scenario Manager the Show button. By selecting a scenario and by clicking the Show button we see the output of our model based on the input variables of that scenario. Although by choosing different scenarios and pressing the Show button we see the various model outcomes, if we have several scenarios we can quickly forget the results for each one. More importantly, we have no real way of comparing the results of the various scenarios. Each time we change a scenario, the previous one is lost. To address this issue we can use the Scenario Manager’s Summary button to keep track of all the available scenarios in a consolidated scenario report.
Therefore, in the Scenario Manager, as shown in Exhibit 7.5, if we press the Summary button, the Scenario Summary dialog box appears (Exhibit 7.6). We then select, for Report type, the Scenario Summary. Finally, in the Result cells box we choose cell B6 which is our simple model’s output or the NPV of the project (see Exhibit 7.6). By pressing the OK button, a Scenario Summary sheet is added automatically to our workbook (Exhibit 7.7).
If we click on the “Scenario Summary” worksheet we see the 3 scenarios we have added to the Scenario Manager plus the current values of the selected changing cells of the model.
Note that the current values are the same as the ones of the base case scenario. The same of course applies for the result cell. This happened because when we added the base case scenario and we chose cells B1:B3 as the changing cells we did not change their values but
EXHIBIT 7.5 Three scenarios have been added to the Scenario Manager
left them as they were. Thus, column D does not add any value and we may hide it or delete it. Furthermore Row 4 presents the comments typed in each scenario and thus we may either delete it or hide it by clicking the - buttons at the left side of the worksheet.
Finally, we may rename both the changing cells and the result cell. So instead of
$B$1 we may type Growth rate,
$B$2 we may type Discount rate,
$B$3 we may type Inflation rate,
respectively. Similarly, instead of $B$6 we may type the NPV of the project. By doing so it is easier to remember at a future point in time which was the changing variable and it will defi-nitely be easier for a third party to understand the Scenario Summary sheet. Now after delet-ing Rows 11 to 13 and adddelet-ing the piece of information to the footer as described in Section 6.4 we are ready to print the report for further interpretation.
When the Scenario Summary dialog box appeared (Exhibit 7.6), under the Report type, there was another option, that of the Scenario PivotTable report. A PivotTable report is an interactive table that automatically extracts, organizes, and summarizes a large list of data.
Nevertheless, PivotTables are beyond the scope of this book and we will not use them in the context of the scenario analysis described in this chapter.
As a final note to this section, I would like to note that the “Scenario Summary” work-sheet is a static report that does not change if the scenario data changes. In this case you can create a new Scenario Summary when necessary, copy the renamed changing result cells from the old worksheet to the new one, and then delete the old worksheet. The new “Scenario Summary” worksheet will have the name “Scenario Summary 2”.
EXHIBIT 7.6 Choosing the output cell that will be presented in the Scenario Summary report