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Financial Modeling with Crystal Ball and Excel, + Website, 2nd Edition by John Charnes

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CHAPTER 1

Introduction

Life is stochastic. Anyone who works in business or finance today knows quite well that future events are highly unpredictable. We often proceed by planning for the worst outcome while hoping for the best, but most of us are painfully aware from experience that there are many risks and uncertainties associated with business endeavors. Even engineers who grew accustomed to calculating the precisely correct answer to textbook problems in school now realize that variation plays an important role in real-world problems.

Many analysts begin creating financial models of risky situations with a base case, constructed by making their best guess at the most likely value for each of the important inputs feeding a spreadsheet model, to calculate the output values that interest them. Often, they account for uncertainty by thinking of how each input in turn might deviate from the best guess and letting the spreadsheet calculate the consequences for the outputs. Such a “what-if” analysis provides insight into the sensitivity of the outputs to one-at-a-time changes in the inputs.

Another common procedure is to calculate three scenarios: best case, worst case, and most likely. This is done by inserting the best possible, worst possible, and most likely values for each key input, then calculating the outputs of interest for each of these scenarios. Such a scenario analysis shows the ranges of possibilities for the outputs, but gives no idea of the likelihood of output values ...

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