CFO Roundtable

CFO Roundtable
Breakfast Meeting
Strategic Gains from
Uncertainty and Risk
Thesis: The traditional planning process deals poorly with

uncertainty.
Point-in-time.
Can't tell whether the Base

Case is the mean, mode,
median ormore likelyan
arbitrary product of
negotiation.
Can't tell whether the Worst

Case represents a 0.01%
probability or a 25%
probability.
Provides no guidance six

months out about how to get
back on plan if off.

uncertainty.
Pro Forma New OSB Mill
Production Calculations
Mill Capacity (MSF)
Demand/Capacity Ratio
Units Produced and Sold (MSF)
Sheathing % of Total Volume
Sheathing Volume
Non-Sheathing % of Total Volume
Non-Sheating Volume
...
1994
1995
1996
2010
0
108.5%
0
100.0%
0
0.0%
0
78,750
91.3%
71,890
100.0%
71,890
0.0%
0
353,500
91.6%
323,773
100.0%
323,773
0.0%
0
406,339
82.4%
335,005
100.0%
335,005
0.0%
0
Sales Calculations
Avg Sheathing Selling Price ($/MSF)
$228.85
Sheathing Sales
0
Avg Selling Price Non-Sheathing ($/MSF) $228.85
Non-Sheathing Sales
0
$216.33
15,552
$216.33
0
$207.43
67,161
$207.43
0
$295.67
99,051
$295.67
0
Gross Sales (000's)

Less: Discounts (000's)
Claims (000's)
Net Sales (000's)
$15,552
0
0
15,552
$67,161
0
0
67,161
$99,051
0
0
99,051
16,490
25,117
Free Cash Flow (000's)
$0
0
0
0
* 0* *
PV Factor
PV Free Cash Flow
Sum of Forecast Free Cash Flow
Perpetuity Value
Total Value (000's)
Point-in-time.
Inflexible.
Forecast
4,301
0.000
0
93,870
38,626
132,495
0.942
15,526
0.174
4,380
Chart-of-accounts based.
Not adaptive.

uncertainty.
Example:
Valuing Incentive
Stock Options
$40
Point-in-time.
Inflexible.
Mathematically abstruse.
Option Value
Exercise Value
$30
Option Value at Grant
Percei ved
Value at Grant
$20
Value of
Option
Black-Scholes (with dividends)
Option Value Today
c Po N ( d1 ) Xe
$10
2
Po
rf N N
2
X
($10)
$40
$50
Po
2N
rf N
X
2
log
d2
Percei ved
Value Today
Slope: 1.0
$60
$70
Stock Price
$80
$90
$100
N (d 2 )
log
Where : d1
$0
rf N
N
N ( d ) cumulative normal probability density function
P P E PV
o
div
(1 coe ) n 1
(1 r f ) n
n 1
E PVdiv Po
(1 rf ) N (1 coe ) N
Po
N
( rf coe )(1 rf )
Where : E PVdiv present value of expected dividends before exercise
= expected dividend yield

uncertainty.
Point-in-time.
Inflexible.
Mathematically abstruse.
Reactive.
Does not anticipate or plan for

contingencies.
Results in renegotiation and

sand-bagging.
Impact: Dysfunctional strategic planning.
Bottom-line orientation.
Management of variances rather

than achievements.
Disconnect between value drivers

and performance measures.
Short-term perspective.
Tacit reward of negotiating skills.
Sluggish response to uncertainties.
Tension between line managers and

the corporate office.
A command-and-control approach to financial reporting and planning.
The three paradoxes of value-based management
Vision
Uniform cost of capital for each

business unit.
Projects selected on basis of rank IRR

or EVA.
Vision
Uniform cost of capital for each

business unit.
Projects selected on basis of rank IRR
or EVA.
Reality
Capital costs differ wildly between projectseven within

business units.
Line managers forced to forgo projects which, on paper,

promise profitable EVA.
Vision
Decentralization and empowerment

lead to improved responsiveness,
coordination, feedback and accuracy.
Vision
Decentralization and empowerment

lead to improved responsiveness,
coordination, feedback and accuracy.
Reality
Decentralization and empowerment lead

to inconsistent assumptions, benchmarks
and objectives.
Vision
1996
1997
1998
Managers encouraged to pursue all

value-enhancing opportunities, whether
from efficiency improvements,
downsizing or growth.
Vision
Reality
1996
1996
1997
1997
1998
1998
Managers encouraged to pursue all

value-enhancing opportunities, whether
from efficiency improvements,
downsizing or growth.
Managers pursue marginal product line

extensions and efficiency gains, instead of
identifying new opportunities.
The central issue is risk.
Differing risk perceptions impede

successful project selection and
financing.

financing.
Capital budgeting distorted by

ignoring asymmetries in the
distribution of value drivers.

financing.

Valuation efforts compromised by

confusing goals with expectations,
modes with means.

financing.

Valuation efforts compromised by

confusing goals with expectations,
modes with means.
Financing decisions distorted by

not gauging downside risk
accurately, and by not evaluating
the fatness of tails.

financing.
Volatility in value drivers beyond

managements control frustrates
decentralized decision-making.

financing.

Communication disrupted between

corporate office and the field.
The relationship
between weather and
performance means...

financing.

Communication disrupted between

corporate office and the field.
Its easy to confuse

bad luck with bad
management.

financing.

Because growth-oriented strategies are

comparative long shots, managers held
accountable to objective metrics will
instead cut costsregardless of the
opportunity foregone.

financing.

Because growth-oriented strategies are

comparative long shots, managers held
accountable to objective metrics will
instead cut costsregardless of the
opportunity foregone.
Incentive payments rendered

arbitrary by not reflecting
difficulty of attainment.
The modern approach

to applied finance
Build models, not chart-of-account

forecasts, which explain business
behavior.
The modern approach

to applied finance

behavior.
Features:
Well-understood rules.
Conceptually intuitive.
Explicit articulation of uncertainty.
Conclusions determined by visible,

verifiable results, not abstract formulas.
The modern approach

to applied finance

behavior.
Features:

Characteristics:
Probabilistic.
Multi-period.
Adaptive.
Proactive.
The modern approach

to applied finance

behavior.
Features:

Characteristics:
Probabilistic.
Multi-period.
Adaptive.
Proactive.
The modern approach

to applied finance

behavior.
Features:

Characteristics:
Probabilistic.
Multi-period.
Adaptive.
Proactive.
Case Example 1: Evaluating the Yield Curve.

Issue:
In 1994, at least one investment
bank claimed the yield curve was
too steep for a stable inflationary
environmentand thus offered
arbitrage opportunities to the
savvy corporate finance
department.
8%
7%
6%
Expected
YTM
5%
4%
3%
2%
1%
0%
0
100
200
300
Months til Maturity
400
Means of testing hypothesis:

Macro-driven simulation of
Treasury bond returns.
Go to Spreadsheet
Expected
YTM
8%
Conclusions:
7%
6%
The yield curve was reasonably

consistent in 1994 with
stationary inflation expectations.
There did not appear, given

actual prices and historical
volatility, to be a sound basis for
betting long-term government
instruments against short ones.
5%
4%
3%
2%
1%
0%
0
100
200
300
Months til Maturity
400
Case Example 2: Evaluating Integrated or Concentric Risk

Insurance Programs.
Contention:
Combining all lines of coverage
under a single, multi-year companywide program should reduce
insurance costs by eliminating
administrative costs and better
utilizing the companys consolidated
ability to retain risk.
250%
PL
Variability
in Amount 125%
per Claim
(Severity)
EEOC
D&O
Env
PBM
GL
AL
WC
AP
0%
0%
Marine
20%
40%
Variability in Claim Count (Frequency)

Wor st Case
7 5th Percentile
Median
Challenge:
Quantifying capacity to retain risk,
given the highly uncertain nature of
casualty and property losses.
Structuring an integrated program
which actually saves money for the
company.

Insurance Programs.
Simplified
Flowchart:
Simulation ...
Simulation 2
Frequency
Severity
Simulation 1
Incurred
Loss
Insurance
Allocation
of Loss
Payment
Pattern
PV Factor
Impact on
Cash Flow
Impact
on
Value
Multiple
Simulations
Confidence Map of
Each Risk Parameter
User-defined parameters
Computer-generated output
Go to Model

Insurance Programs.
Conclusion:
It is possible to quantify, with
reasonable precision, a companys
exposure to various sources of risk,
and to assess how those risks
interact and affect cash flow.
250%
PL
Variability
in Amount 125%
per Claim
(Severity)
EEOC
D&O
Env
PBM
GL
AL
WC
AP
0%
0%
Marine
20%
40%

Wor st Case
7 5th Percentile
Median

Insurance Programs.
Projected Benefits:
250%
PL
Variability
in Amount 125%
per Claim
(Severity)
EEOC
Improved awareness and understanding

of risk. Improved risk containment.
Better identification of areas requiring

insurance and/or hedging.
Better levels of self-insurance and

excess retained risk.
Less duplication of analysis and

administration.
Change in the way managers think

about (and plan around) uncertainty.
D&O
Env
PBM
GL
AL
WC
AP
0%
0%
Marine
20%
40%

Wor st Case
7 5th Percentile
Median
Case Example 3: Evaluating Growth Opportunities in the

Structural Panels Industry.
Average Selling Price
Because of tolerance for smaller

logs, OSB costs were $25 to $50 per
MSF cheaper than Southern
plywood...
Context:
In 1994, the industry could
do no wrong. Price far
exceeded cost for most
producers and almost
everyone was betting on
growth through OSBan
engineered substitute for
plywood.

Total OSB Capacity
(BSF)
25
20
Canada
West
South
NC
NE
15
10
0
1991 1992 1993 1994 1995 1996 1997 1998 1999 2000
Source: RISI (7/95)
Nearly 10 billion square feet additional

capacity projected on a combined base
of 32 billion square feet.
Context:
In 1994, the industry could
do no wrong. Price far
exceeded cost for most
producers and almost
everyone was betting on
growth through OSBan
engineered substitute for
plywood.
Question:
Was the industry overextending itself, or poised
for still further value-adding
growth?
What should the clients
policy be on OSB and
plywood investments?

Impact of OSB Expansion on
Demand/Capacity Ratios
Assuming No Reductions in Plywood Production
(BSF)
45
110%
40
35
OSB Capacity
100%
30
25
20
90%
15
10
80%
Plywood Capacity
(assuming no mill
closures)
Total Demand
Demand Capacity
Ratio
5
0
70%
1991 1992 1993 1994 1995 1996 1997 1998 1999 2000
Source: RISI (7/95)


5 Demand Regions (plus exports)
6 Demand Types
Approach:
Convert a complex body of financial
data and line expertise into a userfriendly model of industry and business
unit performance.
2 Major Products
10 Supply Regions
Plywood
OSB
2 Log Classes
3 Log Species
3 Owner Types
More than 160 Distinct Mills
3 Competing Uses of Fiber
80-120 Quarters

Approach:
Convert a complex body of financial
data and line expertise into a userfriendly model of industry and business
unit performance.
Deliverables:
A pricing model for finished product

and raw material for each mill.
A model for identifying and weeding

out under-performing mills, taking into
account each owners willingness to
endure pain.
A model for weighing different

strategies prospects of creating value.





33
Supply and
Demand (1994)
3;3
3m3
33
Supply and
Demand (2003)
33
3
2
Billion Square Feet (3/8" Basis)
Conclusions:
In simulation after simulation, the supply curve flattened as plywood mills cut
costs and OSB mills entered production. But demand increased only marginally,
causing wholesale erosion in prices.

33
Supply and
Demand (1994)
393
3j3
33
33
Existing OSB
Capacity
Projected
OSB
Expansion
(Aggressive
Case)
Supply and
Demand (2003)
Remaining Plywood
Capacity
(Aggressive Growth Case)
3
7
/
Y
Billion Square Feet (3/8" Basis)
Conclusions:
At the same time, competitors willingness to endure pain meant protracted excess
capacity, and further flattening of the supply curve. The days of justifying
unproductive mills as an option against volatile product prices were over.

Conclusions:
Because the model simulated performance on a mill-by-mill basis, we were able
to predict who would suffer losses, who would shutter, and who would succeed
long-term.

Conclusions:
We were also able to simulate whether hypothetical new mills could create value
and the confidence intervals around success or failure .

Conclusions:
Although only partially responsible, the model helped formulate an investment
strategy which disavowed further green-field expansion. This was a significant
departure from previous policy.
Summary: The key steps to strategically exploiting

uncertainty.
Build a dynamic and, where

appropriate, behavioral model of
the business.
Differentiate controllable and

uncontrollable uncertainties.
Build goals, performance measures,

investor expectations and strategy
around controllable measures, or
drivers.
Identify and plan for contingencies.

Narrow the tolerances in advance
to minimize cost and expedite
responsiveness.

CFO Roundtable

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CFO Roundtable

Thesis: The traditional planning process deals poorly with

Can't tell whether the Base

Can't tell whether the Worst

Provides no guidance six

Thesis: The traditional planning process deals poorly with

Gross Sales (000's)

Free Cash Flow (000's)

Thesis: The traditional planning process deals poorly with

Option Value at Grant

Black-Scholes (with dividends)

Option Value Today

Where : E PVdiv present value of expected dividends before exercise

= expected dividend yield

Thesis: The traditional planning process deals poorly with

Does not anticipate or plan for

Results in renegotiation and

Impact: Dysfunctional strategic planning.

Management of variances rather

Disconnect between value drivers

Tacit reward of negotiating skills.

Sluggish response to uncertainties.

Tension between line managers and

A command-and-control approach to financial reporting and planning.

The three paradoxes of value-based management

Uniform cost of capital for each

Projects selected on basis of rank IRR

The three paradoxes of value-based management

Uniform cost of capital for each

Capital costs differ wildly between projectseven within

Line managers forced to forgo projects which, on paper,

The three paradoxes of value-based management

Decentralization and empowerment

The three paradoxes of value-based management

Decentralization and empowerment

Decentralization and empowerment lead

The three paradoxes of value-based management

Managers encouraged to pursue all

The three paradoxes of value-based management

Managers encouraged to pursue all

Managers pursue marginal product line

The central issue is risk.

The central issue is risk.

Differing risk perceptions impede

The central issue is risk.

Differing risk perceptions impede

Capital budgeting distorted by

The central issue is risk.

Differing risk perceptions impede

Capital budgeting distorted by

Valuation efforts compromised by

The central issue is risk.

Differing risk perceptions impede

Capital budgeting distorted by

Valuation efforts compromised by

Financing decisions distorted by

The central issue is risk.

Differing risk perceptions impede

Volatility in value drivers beyond

The central issue is risk.

Differing risk perceptions impede

Volatility in value drivers beyond

Communication disrupted between

The central issue is risk.