Chapter 13Risk AssessmentThe Centerpiece of All Valuation, Contracting, and Credit Issues in Finance
One of the tasks required to manage any business is the honest and somewhat boring job of accounting for its historical financial results by keeping track of profit and asset value. A perhaps less noble and much more challenging task faced by all but the very simplest of business endeavors as well as by those who make investments is to make implicit or explicit forecasts of future cash flow. The problem with making such a forecast is that it by definition encompasses an unknown and uncertain future. With the possible exception of forecasting nominal cash flow earned on German government bonds, all cash flow forecasts from all financial models will turn out to be wrong.
Financial modeling techniques described in the first part of the book addressed issues involving how to construct a financial model but did not consider how to quantify potential uncertainty in assumptions for key variables that drive projected revenues, operating expenses, and capital expenditures. This part of the book moves to the more difficult and interesting question of how to assess the uncertainty associated with economic variables such as price, industry demand, expense structure, cost of new production capacity, and interest rates. The amount by which implicit or explicit forecasts of these items could differ from realized results forms the framework for thinking about risk. This framework contrasts with ...