Project Management

Analysis of Project Risk

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Need for risk assessment

All business decision have risk associated with them. In Capital Budgeting, costs & benefits extend over long period so risk is more. Investment Proposals differ in risk profile. R&D project, Expansion Project, Diversification Project- all bear different degrees of risk. Hence, the need for evaluating risk in a Capital Expenditure Proposal.
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Types of Risk
Project Specific Risk Cash flows not as per expectation. Estimation Error, poor management, poor execution, over run on time and cost. Competitive Risk Revenues from sales and market share affected by unexpected competition in the market. Market Risk Unexpected changes in macro economic factors like GDP growth rate, interest rate fluctuation, inflation rate, political risk etc. that affects all projects alike. Industry Specific Risk Government policy towards the industry, regulatory environment , demand for products, technological changes etc.
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Measure of Risk
Risk refers to variability of expected returns Important measures used are

Range
Standard Deviation

Coefficient of variation
Semi variance
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Perspectives on Risk
Stand alone risk
Risk of a project when viewed in isolation. Firm Risk ( Corporate Risk) Contribution of the project to the total risk of the firm.

Market Risk or Systematic Risk

Risk of a project when viewed from the point of view of a diversified investor.
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Tools for Risk Analysis

Sensitivity Analysis, Break Even analysis, Simulation,

Decision Tree Analysis,

Scenario Analysis.

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Sensitivity Analysis
This involves evaluating the impact on cash flows or NPV if certain key variables are changed from those values taken at the time of project evaluation The sensitivity of returns from the project for small percentage changes in key variables allows the managers to get good idea about Risk Profile of the Project. Key variables may be Sales Qty, Price, RM cost, project Cost, market growth etc.
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Break - even analysis

Break even analysis helps to know how much should be produced and sold at a minimum to ensure that the project does not lose money. The minimum quantity at which loss is avoided is called break even point. May be defined in accounting and financial terms.

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Accounting break even analysis.

Break even level of sales will be: FC+Depreciation / Contribution margin ratio.

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Financial break even analysis

Focus is on NPV. At what level of sales will the project have a zero NPV

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Simulation Analysis
It may be used for developing the probability profile of a criterion of merit by randomly combining values of variables which have

a bearing on chosen criteria. Simulation consists of one or more

trial runs of a process to learn that its possible outcomes using a

model that is as representative as is necessary for the simulation

of the realistic.
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Procedure
1. 2. 3. 4.

5. 6.

Model the project. Specify the values of the parameters and the probability distributions of the exogenous variables. Select a value, at random, from the probability distributions of each exogenous variables. Determine the NPV corresponding to the randomly generated values of the exogenous variables and pre-specified parameter values. Repeat steps (3) and (4) a no. of times to get a large no. of simulated NPVs. Plot the frequency distribution of the NPV.

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Project Management

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Decision Tree analysis

A decision problem can be represented with the help of diagram in the form of a tree , for clear and systematic idea. The alternative courses of action, states of nature , likely outcomes etc. are graphically/ diagrammatically depicted as if they are branches and sub branches of a horizontal tree. Hence this is known as a Decision Tree Diagram

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 The Decision Tree consists of a net work of nodes, probability estimates, pay offs. There are two types of Nodes viz. Decision Nodes represented by a small square and Chance Nodes represented by a small circle. Alternative courses of action originate from Decision Node in the main branch.

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 At the terminal point of the decision node , chance node emanates as sub branches. Probability and outcomes are shown along the sub branches. Each sub branch can form branch again so that we can build a tree like structure representing all possible outcomes

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Steps in Decision Tree Analysis

Identifying the problem and alternatives Delineating the decision tree Specifying probabilities and monetary outcomes Evaluating various decision alternatives

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Scenario Analysis
In sensitivity analysis, typically one variable is varied at a time. If variables are interrelated, as they are most likely to be, it will be

helpful to look at some plausible scenarios, each scenario

representing a consistent combination of variables.

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Procedure

Select the factor around which scenarios will be built. The factor chosen must be the largest source of uncertainty for the success

of the project.

Estimate the values of each of the variables in investment

analysis for each scenario.

Calculate the NPV and/or IRR under each scenario.

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Risk adjusted discount rate

It involves increasing cut-off rate or discount rate to reflect project risk by a certain % on account of risk while calculating NPV.

The projects which are more risky and which have greater
variability in expected returns should be discounted at a higher

rate as compared to the projects which are less risky and are
expected to have lesser variability in returns and vice versa.
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