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
14 - 15 February 200211th Annual QAD Conference
AUDIT QUALITY
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
14 - 15 February 200211th Annual QAD Conference
AUDIT QUALITY
DIVISION
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
14 - 15 February 200211th Annual QAD Conference
AUDIT QUALITY
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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
14 - 15 February 200211th Annual QAD Conference
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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
14 - 15 February 200211th Annual QAD Conference
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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
14 - 15 February 200211th Annual QAD Conference
AUDIT QUALITY
DIVISION
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.
14 - 15 February 200211th Annual QAD Conference
AUDIT QUALITY
DIVISION
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
14 - 15 February 200211th Annual QAD Conference
AUDIT QUALITY
DIVISION
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
14 - 15 February 200211th Annual QAD Conference
AUDIT QUALITY
DIVISION
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
14 - 15 February 200211th Annual QAD Conference
AUDIT QUALITY
DIVISION
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.
14 - 15 February 200211th Annual QAD Conference
AUDIT QUALITY
DIVISION
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.
14 - 15 February 200211th Annual QAD Conference
AUDIT QUALITY
DIVISION
ISO 9001 2000
The required business practices in this “Quality Management Standard” are sound operating
principles that should maximize efficiency (and profits!)
14 - 15 February 200211th Annual QAD Conference
AUDIT QUALITY
DIVISION
Why Evaluate Projects?
Investor Due Diligence – to Protect Investors
Compliance Audits – To Verify Quality Management System (ISO 9001 2000)
14 - 15 February 200211th Annual QAD Conference
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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.
14 - 15 February 200211th Annual QAD Conference
AUDIT QUALITY
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What is Due Diligence?
According to me:
The act of protecting entities from harm caused by a process or event.
14 - 15 February 200211th Annual QAD Conference
AUDIT QUALITY
DIVISION
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.
14 - 15 February 200211th Annual QAD Conference
AUDIT QUALITY
DIVISION
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.
14 - 15 February 200211th Annual QAD Conference
AUDIT QUALITY
DIVISION
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
14 - 15 February 200211th Annual QAD Conference
AUDIT QUALITY
DIVISION
Sources of Technical Projects
New or emerging technologies (Risky Projects are both the Best and the Worst)
Big national science
Successful technical companies
14 - 15 February 200211th Annual QAD Conference
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TABU (Technical Axiom of Business Uncertainty)
The less you know about a project, the higher your uncertainty regarding the project!
14 - 15 February 200211th Annual QAD Conference
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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
14 - 15 February 200211th Annual QAD Conference
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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
14 - 15 February 200211th Annual QAD Conference
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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
14 - 15 February 200211th Annual QAD Conference
AUDIT QUALITY
DIVISION
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!
14 - 15 February 200211th Annual QAD Conference
AUDIT QUALITY
DIVISION
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”
14 - 15 February 200211th Annual QAD Conference
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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!
14 - 15 February 200211th Annual QAD Conference
AUDIT QUALITY
DIVISION
The Process of Technical Systems Analysis
Define Technical Scope Technology & Scaling Operational Process Marketing & Sales Methodology Legal & Regulatory Issues Operational Model (with quantified
uncertainty!)
14 - 15 February 200211th Annual QAD Conference
AUDIT QUALITY
DIVISION
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)
14 - 15 February 200211th Annual QAD Conference
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The Metric
Process Metrics – Percent Idle Time, Manufacturing Time
Economic Metrics – Net Discounted Cash Flow, Profitability Index
14 - 15 February 200211th Annual QAD Conference
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Accuracy & Precision
Precise Accurate
14 - 15 February 200211th Annual QAD Conference
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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
14 - 15 February 200211th Annual QAD Conference
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Different Analyses
Single Valued Analysis
A = 1023 ft x 753 ft
A = 770,319 ft2
14 - 15 February 200211th Annual QAD Conference
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Different Analyses
Standard Error Propagation
A = 1023 ft x 753 ft
A = 770,319 ft2
= 74,096 ft2
(symmetric )
14 - 15 February 200211th Annual QAD Conference
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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)
14 - 15 February 200211th Annual QAD Conference
AUDIT QUALITY
DIVISION
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
14 - 15 February 200211th Annual QAD Conference
AUDIT QUALITY
DIVISION
Gaussian Frequency Distribution
0100200300400500600700800900
1000
120 140 160 180 200 220 240
14 - 15 February 200211th Annual QAD Conference
AUDIT QUALITY
DIVISION
Gaussian Cumulative Distribution
0.0
0.2
0.4
0.6
0.8
1.0
1.2
120 140 160 180 200 220 240
14 - 15 February 200211th Annual QAD Conference
AUDIT QUALITY
DIVISION
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
14 - 15 February 200211th Annual QAD Conference
AUDIT QUALITY
DIVISION
Gaussangular Distribution
0.00
0.01
0.02
0.03
0.04
0.05
100 120 140 160 180 200
14 - 15 February 200211th Annual QAD Conference
AUDIT QUALITY
DIVISION
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
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