AUDIT QUALITY DIVISION 14 - 15 February 200211 th Annual QAD Conference Technical Due Diligence &...

14 - 15 February 200211th Annual QAD Conference

AUDIT QUALITY

DIVISION

Technical Due Diligence & Monte Carlo Risk Analysis

James F. Wright (Ph.D. in Physical and Nuclear Chemistry)

http://www.drjfwright.com

http://www.montecarloriskanalysis.com


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DIVISION

Technical Due Diligence and Monte Carlo Risk Analysis

Outline

Technical Due Diligence & Quality Audits Applicable Projects (Type & Size) The Technical Due Diligence Team Technical Systems Analysis Technical (Monte Carlo) Risk Analysis


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Two-Cow Feudalism

You own and care for the cows

You & your cows live on your lord’s estate

Your lord takes some of your milk


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Two-Cow Fascism

The government confiscates your cows

You are hired to care for the cows

The government sells you milk


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Two-Cow Communism

You “donate” both cows to the community

The community cares for the cows

The milk is made available to the community as needed


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Two-Cow Totalitarianism

The government confiscates both of your cows

The government denies they ever existed

You are drafted as an Army Private

Only 50 most powerful in government get milk


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Two-Cow Traditional Capitalism

You own two cows You sell one cow & buy a bull You establish Dairy Farm You establish Beef Cattle Operation Your business prospers and you retire on the

income.


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Two-Cow “Dot Com” Capitalism

You own two cows

$500 million IPO (your two cows, 500 PC’s & associated facilities)

Company sells milk over the internet

Company has no profit but sales grow


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Two-Cow “Dot Com” Capitalism (cont.)

You pump Company’s stock

You exercise $15 million golden parachute

The company files for Chapter 11

You have local grocery store deliver milk to your house


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Two-Cow Ethereal Capitalism

You have two real cows You sell all three of them to your publicly

listed company using a letter of credit opened by your brother-in-law at the bank

You initiate a debt/equity swap with an associated general offer and get all four cows back with a tax exemption for five cows


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Two-Cow Ethereal Capitalism (cont.)

Milk rights for six cows transferred (via an intermediary) to Cayman Island company you secretly own

Cayman Island company sells the rights to all seven cows back to your publicly listed company

The publicly listed company’s Annual Report states it owns eight cows with an option for another.


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Quality Audit

A systematic, independent examination of the quality system to determine: whether both the

quality system activities, and the results of such activities, comply with quality system

procedures; that these procedures are implemented effectively; and that these

procedures are suitable to achieve quality system objectives.


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ISO 9001 2000

The required business practices in this “Quality Management Standard” are sound operating

principles that should maximize efficiency (and profits!)


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Why Evaluate Projects?

Investor Due Diligence – to Protect Investors

Compliance Audits – To Verify Quality Management System (ISO 9001 2000)


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What is Due Diligence?

According to Webster:

The care that a reasonable person exercises under the circumstances to avoid harm to other persons or property.


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What is Due Diligence?

According to me:

The act of protecting entities from harm caused by a process or event.


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What is Technical Due Diligence?

According to me:

The act of protecting entities, that utilize new or emerging technologies (i.e., risky projects!), from harm caused by a process or event.


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What is Due Diligence

My QA Definition:

The act of protecting entities from harm caused by a process or event by verifying the existence of a comprehensive Quality Management System.


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Types of Projects

Conventional Projects - Success determined by conventional business parameters

High-Tech Projects - Success determined by above plus Internet-related factors

Technical Projects - Success determined by above plus ability to develop new or emerging technologies


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Sources of Technical Projects

New or emerging technologies (Risky Projects are both the Best and the Worst)

Big national science

Successful technical companies


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TABU (Technical Axiom of Business Uncertainty)

The less you know about a project, the higher your uncertainty regarding the project!


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Some Corollaries of TABU

Those that treat a pro forma as fact are showing you how little they know about the project

Surprises will usually adversely effect the project

Cost estimates will usually be underestimated Income estimates will usually be

overestimated


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More Corollaries of TABU

Uncertainties increase as estimations are moved farther into the future

The added cost of technologies must usually be repaid at the end of the project

New technologies seldom lower up-front expenses

Expected savings from operating in less-developed countries are usually fiction


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The Thesis

Projects with high risk need a more sophisticated method of due diligence

The uncertainty in high-risk projects should be quantified


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Elements of the Technical Due Diligence Process

Form a Technical Due Diligence Team – Qualifications determined by Project’s Character and Relative Risk

Technical Systems Analysis - Will technology work as advertised?

Technical Risk Analysis - Quantify the risk!


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Technical Due Diligence Team

Project Manager - Expert, confidence of client, no conflict of interest, focused, manager

Marketing, Technical, Legal, Finance, etc. Team Members - Qualified experts, no conflicts of interest, “loose lips sink ships”


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Basis of Technical Systems Analysis

A technology is unproven until it has been demonstrated to work at the required scale as

planned!


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The Process of Technical Systems Analysis

Define Technical Scope Technology & Scaling Operational Process Marketing & Sales Methodology Legal & Regulatory Issues Operational Model (with quantified

uncertainty!)


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Technical Risk Analysis

Define a Scenario - Business Model

Evaluate the Consequences of the Scenario - determined by the investor-selected metric and analysis methodology (Monte Carlo)


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The Metric

Process Metrics – Percent Idle Time, Manufacturing Time

Economic Metrics – Net Discounted Cash Flow, Profitability Index


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Accuracy & Precision

Precise Accurate


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Sources of Error

Random Error - caused by chance, not reducible, no effect on accuracy (most likely value), effects precision

Uncertainty - determined by assessor and their (lack of) knowledge, effects most likely value, accuracy and precision


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Different Analyses

Single Valued Analysis

A = 1023 ft x 753 ft

A = 770,319 ft2


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Different Analyses

Standard Error Propagation

A = 1023 ft x 753 ft

A = 770,319 ft2

= 74,096 ft2

(symmetric )


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Different Analyses

Monte Carlo Simulation

Took 20 measurements of each side Created a distribution function for each side Used 50,000 iterations A = 771,897 ft2

= 6,508 ft2 (from FWHM of distribution function)


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Monte Carlo Risk Analysis

Use metric that client understands

Monte Carlo calculates answer to metric that reflects the uncertainties of each of the input parameters


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Gaussian Frequency Distribution

0100200300400500600700800900

1000

120 140 160 180 200 220 240


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Gaussian Cumulative Distribution

0.0

0.2

0.4

0.6

0.8

1.0

1.2

120 140 160 180 200 220 240


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The Monte Carlo Process

Determine metric (A = p + xy/z) Determine distribution function for p, x, y, & z Start Iterative Process

- Use PRNG to get values for p, x, y, & z to be used in this iteration

- Calculate A for this iteration Continue Iteration until OK


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Gaussangular Distribution

0.00

0.01

0.02

0.03

0.04

0.05

100 120 140 160 180 200


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The Book!

“Monte Carlo Risk Analysis and

Due Diligence of New Business Ventures”by James F. Wright

Publisher - AMACOM (August, 2002, release) Monte Carlo software included on CD Two detailed examples in book that use software 30 Tables, 49 Figures/Screens, 480 Equations

AUDIT QUALITY DIVISION 14 - 15 February 200211 th Annual QAD Conference Technical Due Diligence &...

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