The CPA Congress is a premium global event for strategic business leaders. The 2010 event was held in New South Wales, Queensland and Tasmania. Dr Liam Bastick, Director of Corality (Melbourne) was invited to deliver a series of presentations and workshops during the course of the event.

Risk, return and ranking in business modelling

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Presentation: 3Rs of Modelling

In his presentation, “3Rs of Modelling”, Liam Bastick discussed the nature of risks and the techniques used to validate models in order to decrease model errors and enable managers to form decisions on more accurate information.

"I really enjoyed this presentation. It was a great opportunity to concentrate on best practice modelling, and how to identify and mitigate for modelling risks in Excel, a passion of mine" – Liam Bastick.

Quantifying decisions through models is common practice. However, the difficulty lies in objectively assessing the assumptions and risks within those models to ensure management decisions are based on valid models.

Industry statistics and research have shown that models currently used widely in corporate finance contain errors. When businesses are forced to rely on these models, they make the wrong decisions, decisions that can lead to unprofitable projects, declining stock prices and even bankruptcy. As usual, the old saying, Garbage in, garbage out (GIGO), applies.

Importance of understanding risk and model validation

In the “3Rs of Modelling”, Liam Bastick outlined some alarming statistics regarding errors in models:

• According to KPMG, errors are widespread in spreadsheets: 90% of all Excel spreadsheets with more than 150 rows of Excel formulae contain material errors
• Research conducted by R. Panko (1998) indicated that MBA students with over 250 hours of spreadsheet development experience had 24% chance of introducing spreadsheet errors into the first worksheet they built

Furthermore, in the aftermath of the GFC, the issue of being able to objectively assess model risk has been growing in importance.

Management decisions are based on financial model outputs. Thus, it is necessary to be able to objectively critique and review used models to ensure decisions are based on accurate information.

The “3Rs of Modelling” introduces some critical tools to help you reduce risks inherent within models. Below is an overview of what was covered in the presentation.

Presentation snapshot

The “3Rs of Modelling” is about the 3R’s of risk, return and ranking. It illustrates the different types of risks commonly encountered in investment projects:

• Business risks
• Key man risk
• Model risk

Business risks are about the uncertainties attached with business operations and impacts on future expected returns. Key man risk indicates the risks associated with an over-reliance on a few key individuals to build and maintain models.

Model risk – Elements to consider

• Inherent risk, risk associated with the nature of the environment, the project being modeled, the model itself and the nature of the modeler
• Control risk, risk concerned with whether or not adequate checks and controls are in place to enable the model to proactively raise issues
• Detection risk, risk linked with the review process to verify the model

Returns and Ranking

The “3Rs of Modelling” covers issues associated with project returns and the methods used to rank investment proposals:

• NPV vs. IRR
• Common computational errors
• Identifying key drivers, outputs and constraints
• Ranking techniques
• Factor analysis

Key findings

Make sure to:

• Understand the nature of assumptions, inputs, and outputs
• Control model complexity
• Establish appropriate checks and controls to manage risk
• Employ adequate review processes to detect risk

Download presentation

Click here to view and download a condensed version of the presentation from SlideShare.