Corporate Finance departments are tasked with identifying and accounting for abstract concepts such as uncertainty. Over time the accountancy profession has developed mechanisms for accounting for uncertainty and creating systems for determining projects to a mathematical value. This article will highlight some of the techniques used.
Accounting for Uncertainty
Sensitivity analysis is the formula for accounting for uncertainty. Essentially the assessor creates variations on different metrics and looks at the outcomes on the project. The level of response indicates the extent to which that particular project is sensitive to external factors. Where a project is found to be individually more responsive than other similar projects, then extra care needs to be taken when varying the metrics.
As the corporate finance teams begin to understand the intricate workings of the organization, they will come up with average values and standard testing techniques to ensure consistency across the organization. Sometimes one will hear about the stressing of assets. This simply means putting the asset under an assessment framework where the degree of its responsiveness to changes in the metrics is measured.
Scenarios provide an opportunity to observe the market in action as well as the management reaction. In the experiment, managers will be given the opportunity to make decisions on a given hypothetical investment project. The analyst will review the responses and the decisions taken. The information gathered will then be fed into both a decision making model but also assist in classifying the viability of that asset.
Sometimes you will hear of the crystal ball. The crystal ball is the financial equivalent of a soothsayer because it seeks to create an impression of predictability by analyzing the multiple responses to external factors that assets and projects experience. It is not a particularly rigid system of analysis and it would be foolish to take it for the bible truth. Rather it attempts to rationalize the seemingly irrational, to measure the seemingly immeasurable and to give accounting meaning to the daily business dynamics that happen in a firm.
Organizational learning will then also pick up some data from this corporate finance model for predicting outcomes. If for example a particular aspect of a management decision reported to the corporate finance team as a loss making enterprise, then the decision and the decision making mechanism will be up for review in the next cycle of managing projects.
As one can see from above, accounting for uncertainty is a very technical process that involves complex mathematical calculations and assumptions. The role of the corporate finance team is to undertake the analysis according to the different criteria that have been presented and then experiment until they achieve a level of predictability in outcomes that can match the uncertainty that characterizes all business activity.
Business thrives if it can predict how the market will react to certain conditions or changes in conditions. Therefore if the corporate finance department is able to predict with some certainty that certain actions will lead to certain outcomes, then they are well on their way to assisting the bottom line of the company.