PROJECT ASSESSMENT

March-April 2007

Prof.: Sarah Cordero

Problem Set #4
Risk Analysis of Cheese Inc.
The United Dairy Products (UDP) managers assigned to the Cheese Inc. project were not
convinced with the results which were obtained from the deterministic financial analysis.
Therefore, the President of Cheese Inc. asked to know how changes in some of the variables
might affect the project outcome.
The President of Cheese Inc. hired Corderos consulting company, to study the trends in the
financial variables that might affect the project. The consulting group has identified the prices
of cheese, milk, fuel, and domestic inflation as the variables critical for the viability of the
project. In addition, they found that the automatization of the plant can increase production in
year 2, but depending on the portion of the process automated, the increase can be 50% or 60%.
The forecast analyst at the consulting group has concluded that the prices of cheese, milk and
fuel follow a normal distribution. They predicted based on trend analysis that the minimum and
maximum real price for milk will be +/- 15% of the base case price respectively. For fuel, the
mean price is 1.5 and the standard deviation is 0.095.
The consulting group found that the price of cheese was actually high and it is unlikely that this
price will hold in the future because of increased competition. The analysts think that over the
life of the project it is more realistic to assume that the real export price of cheese will have an
expected value of 4.9 D$/kg, with a standard deviation of 0.35
Ms. Cordero is of the opinion that the probability distribution of the domestic inflation rate is a
step rectangular. The data presented below is the monthly inflation rate for the past three years.
Build the frequency distribution and use it as a probability distribution. (Use classes with an
interval of 1%. Even though these are continuous numbers use class limits such as 5% to 6%, 6%
to 7%, etc. Hint: The formula =countif in Excel is very useful).
1

9.75%
5.93%
8.76%
6.50%
8.68%
8.42%

8.41%
7.36%
8.05%
6.39%
9.47%
8.31%

5.67%
7.40%
8.60%
8.13%
8.80%
7.26%

7.49%
8.41%
6.99%
7.18%
6.09%
8.53%

7.47%
8.10%
7.85%
9.67%
9.69%
9.48%

8.01%
7.65%
9.33%
6.77%
5.50%
7.53%

The President of Cheese Inc. just hired you to conduct a risk analysis of the planned project to
better understand the variability in the NPV. He/She is also interested in learning about possible
ways to lower the variability of the returns to equity.
1.

Scenario 1. Model the base case scenario with these assumptions, running 1000
simulations.

2.

Scenario 2. Now assume that you were able to find a correlation between the price of
milk and the price of cheese. Analysts had estimated the correlation coefficient to be
0.8. What effect will these assumptions have on the profitability of the project? (Run
1000 simulations, adding this new assumption to scenario 1, keep increase prod. at 60%).

3.

For scenario 3, assume that since Cheese Inc. is the largest consumer of milk in the
town, suppliers were willing to sign a contract in which the maximum price was set at
G$ 5.5. What effect will these assumptions have on the profitability of the project?
(Run 1000 simulations, adding this new assumption to scenario 2).

4.

Now, without running more simulations, analyze:

a)

What would happen if you model the price of cheese for each year as a separate
risk variable, instead of running price as one variable and repeat it for every year.
The prices in year t+1 are independent of the prices in year t.

b)

What would happen if you model a change in the price of cheese for each year as
a separate risk variable, instead of the yearly price itself and the prices in year t+1
depend on the prices in year t.

5.

Make a summary of the results from all the scenarios.