Project Management

A Managerial Approach
Risk Analysis
This chapter-
Theoretical aspects of risk
Types of risk
Risk Management process
Hillier model
Certainty equivalent approach
Risk adjusted discount rates
Sensitivity analysis
Game theory
Monte Carlo simulation (already covered)
Risk Versus Uncertainty
Analysis Under Uncertainty - The
Management of Risk
The difference between risk and uncertainty
Risk - when the decision maker knows the
probability of each and every state of nature and
thus each and every outcome. An expected
value of each alternative action can be
determined
Uncertainty - when a decision maker has
information that is not complete and therefore
cannot determine the expected value of each
alternative
Involved at all stages of project management
What is risk?an event about which we are uncertain
and the possibility of the result is unfavourable.
If it is favourable, it turns out to be an opportunity.

PROJECT RISK is the cumulative effect of the chances of
an uncertain occurrence adversely affecting the project
objectives. Or, the degree to which project objectives are
exposed to negative events and their probable
consequences, as expressed in terms of scope, quality,
time & cost.

Risk
Types of risk
1. Project specific risk- the earnings & cash flows of
the project may be lower than expected due to an
estimation error or lower quality of management
2. Competitive risk -the earnings & cash flows of the
project may be effected by some unanticipated actions
of the competitors
3. Industry -specific risk -unexpected technological
developments & regulatory changes that are specific to
the industry to which the project belongs ,will have an
impact on the earnings & cash flows of the project as
well

4. Market risk -unanticipated changes in macroeconomic
factors like GDP growth rate, interest rate, inflation etc. have
an impact on all projects in varying degrees.
5. International risk -in case of foreign projects exchange
rate risk /political risk may effect cash flows.
An evaluation of potential risks can show at an early stage
whether or not a proposal is worth pursuing.
The risks can be
1) the project will fail completely
2) The project will be compromised on time, cost or both.




Contingency Plans to tackle significant risk situations
should surface in the project proposal. Formal use of
risk analyzing techniques may be required.
Broadly, the steps to gauge risk are:
Anticipating the likelihood of a particular undesirable
event/events happening
The severity of the effects of each of these events on
the project: critical / major / minor
The probability of detection of that undesirable event
occurring

Def: The art & science of identifying, analyzing & responding to
risk factors throughout the life of a project in the best interests of
its objectives.
Identification- break down the project into a no. of manageable
tasks(develop a work breakdown structure)--consider what might
go wrong(by brainstorming/numeric techniques) during the
execution of each task.
Analysis Assigning a probability & amount at stake to each
possible risk event & then summing up the risk event status for all
the risks identified.
Risk event status = Risk probability X Amount at stake
Risk prob. is the LIKELYHOOD that the event will occur
Amount at stake is the extent of loss which could result
Risk MANAGEMENT PROCESS
Response Developing a strategy for how the project team will
respond to each risk event, once it occurs.
EITHER not to take responsibility in the first place OR enter into a
prior contract.
Types of Contract strategy (allocation of risk) usually practiced
are
1. Time & material--- the buyer/customer agrees to pay whatever
it takes to get the job done. Significant cost increase risks have
to be absorbed by the customer.
2. Firm fixed price----opposite of T&M. the customer will pay only
the specified amount & no more. If anything goes wrong, the
contractor/seller assumes all risk overruns.
3. Cost + fixed fee --- reimbursement to the seller for all
allowable costs + an agreed upon fixed
fee(representing the sellers profit)
Risk is shared on a relatively equal basis----the
customers risk is having to pay whatever it costs to
complete the project.----the sellers risk is potentially
reduced profit.
4. Time & material not to exceed contract ----the
customer will pay only for the cost of the work up to a
limit established in the contract. Preventively, the seller
demonstrates chances of change in scope of the
project.

Expected value
Expected value of an event is the possible outcome times
the probability of its occurrence.
e.g., if an activity has a 50% chance of yielding a profit of
$30 million,
Its expected value is 0.5 X 30m=15m
If another activity has 70% chances of yielding$25million, its
Expected value is 0.7X 25=17.5m
Hence the second is preferable.

Risk Analysis
Principal contribution of risk analysis is to
focus the attention on understanding the
nature and extent of the uncertainty
associated with some variables used in a
decision making process
Usually understood to use financial
measures in determining the desirability of
an investment project
Risk Analysis
Probability distributions are determined or
subjectively estimated for each of the uncertain
variables
The probability distribution for the rate of return
(or net present value) is then found by simulation
Both the expectation and its variability are
important criteria in the evaluation of a project
HILLIER MODEL
The risk of the project .reflected in is
considered in conjunction with NPV computed with the
risk free discount rate.
If NPV is computed using a risk- adjusted discount
rate,and then it is viewed along with (NPV), the risk
factor would be counted twice.
2 cases can arise:
a) No correlation among cash flows
b) Perfect correlation among cash flows





o
o
HILLIER MODEL

a) Uncorrelated cash flows
When the cash
flows of different
years are
uncorrelated, the
cash flow for year
t is independent of
the cash flow of
year t-r. Put
differently, there is
no relationship
between cash
flows from one
period to the
other.

I
i
A
V P N
n
t
t

+
=

=1
) 1 (
2
1
1
2
2
) 1 (
) (

=
(

+
=
n
t
t
t
i
NPV
o
o
t
Where NPV =expected net present value
=expected cash flow for year t
i = RISK FREE INTEREST RATE
I = initial outlay
(NPV) = standard deviation of the NPV
= standard deviation of the cash flow
for the year t

t
A
o
t
o
In the above formulae, the discount rate is the
risk free interest rate because we try to
separate the time value of money and the risk
factor. The risk of the project , reflected in the
Standard Deviation of the NPV is considered
in conjunction with the expected NPV
computed with the risk free discount rate. If
expected NPV is computed using a risk
adjusted discount rate and then if this is
viewed along with Standard deviation of NPV,
the Risk factor would be double counted.
b) Perfectly correlated cash flows
If cash flows are perfectly correlated, the
behavior of cash flows in all periods is alike.
This means that the actual cash flow in one
year is alpha standard deviations to the left of
its expected value, cash flows in other years
will also be alpha Standard deviations to the
left of their respective expected values. Put in
other words, cash flows of all years are linearly
related to one another. The expected value
and the Standard Deviation of the NPV when
cash flows are perfectly correlated are as
follows-
I
i
A
V P N
n
t
t

+
=

=1
) 1 (

=
+
=
n
t
t
t
i
NPV
1
) 1 (
) (
o
o
b) Perfect correlation among cash flows

t
Knowledge of NPV & (NPV) is very useful for
evaluating the risk characteristic of a project. If the NPV of
a project is normally distributed, we can calculate the
probability of NPV being less than or more than a certain
specific value.
We calculate the Z value by dividing the difference between
expected NPV & the specified value by NPV
The area value corresponding to Z will represent the
probability associated with NPV being less or more than a
particular specified value.
o
o
Exercise
A project involving an outlay of Rs. 10,000 has the
following benefits associated-

YEAR 1 YEAR 2 YEAR 3
NCF PROB NCF PROB NCF PROB
3000 0.3 2000 0.2 3000 0.3
5000 0.4 4000 0.6 5000 0.4
7000 0.3 6000 0.2 7000 0.3
Calculate Expected NPV and Standard Deviation of NPV
assuming i=6 percent
CERTAINTY EQUIVALENT METHOD
Certainty Equivalent Coefficient
Suppose someone presents you with a lottery, the
outcome of which has the following Probability
Distribution.
Outcome Probability
Rs.1000 0.3
Rs.5000 0.7
You are further asked-how much of a certain amount
would you accept in lieu of this lottery. Say, your reply
is 3,000/-. This represents the certainty equivalent of a
lottery which has an expected value of 3,800Rs.
( Rs.1000*0.3+5000*0.7) and a given distribution. The
factor 3000/3800 is the certainty equivalent coefficient.
The certainty equivalent coefficient
represents 2 different things-
Variability of outcomes
Your attitude towards risk.

Certainty Equivalent Coefficients
transform the expected values of
uncertain flows into their certainty
equivalents.
I
i
A
NPV
t
t t
n
t

=
+
=

=
) 1 (
1
o
Under the Certainty equivalent method, NPV is
calculated as-

The value of certainty Equivalent
Coefficient usually ranges between 0
and 1. A value of 1 implies that the cash
flow is certain or the management is risk
neutral. In industrial situations, cash
flows are generally uncertain and
managements usually risk averse.
Vazeer Hydraulics is considering an investment proposal
involving an outlay of Rs. 45,000,000. The expected
cash flows and certainty equivalent coefficients are-
YEAR EXPECTED CASH
FLOW
CERT EQUIV
COEFF
1 10,00,000 0.90
2 15,00,000 0.85
3 20,00,000 0.82
4 25,00,000 0.78
The risk free interest rate is 5%. Calculate NPV of the
proposal.
Exercise