Corporate and Project Finance Modeling

Chapter 15Presentation of Risk Analysis through Adding Sensitivity Analysis to Financial Models

Risk analysis is often a lot about effective presentation. One of the simplest and most effective ways to analyze risk is through changing one of the inputs to the financial model and gauging the effect on key output variables such as the value of the company, the internal rate of return, or the debt service coverage ratio (DSCR). If management can visualize how a key variable such as energy production affects cash flow and at the same time can see statistics such as the DSCR, there may be little else managers really need to do in analyzing risk. Allowing people to play around with variables and to understand what happens to cash flow, earnings, or debt balances may be one of the most important things you can do with a financial model and a lot of it is about presentation. This sensitivity analysis process involves making an effective display, often with a graph, to illustrate what happens to some measure of value when the level of a key value driver changes.

High-powered analysts who compute statistics such as value at risk (VaR), probability of default, and complex option price premiums for credit default swaps may scoff at sensitivity analysis as being overly simplistic. But consider a variable that is very difficult to predict such as the level of traffic that will occur between England and France in the famous Eurotunnel project, electricity demand growth in the Philippines, ...