Project Management A Managerial Approach

1. Project ManagementA Managerial Approach Risk Analysis

2. 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)

3. 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

4. Risk 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.

5. 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

6. 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.

7. 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

8. RiskMANAGEMENT PROCESS 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

9. 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 • 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. • 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.

10. 3. Cost + fixed fee --- reimbursement to the seller for all allowable costs + an agreed –upon fixed fee(representing the seller’s profit) Risk is shared on a relatively equal basis----the customer’s risk is having to pay whatever it costs to complete the project.----the seller’s 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.

11. 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.

12. 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

13. 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

14. HILLIER MODEL

15. 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

16. 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. t

17. 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

18. 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.

19. 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-

20. b) Perfect correlation among cash flows t

21. 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.

22. Exercise A project involving an outlay of Rs. 10,000 has the following benefits associated- Calculate Expected NPV and Standard Deviation of NPV assuming i=6 percent

23. CERTAINTY EQUIVALENT METHOD

24. 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.

25. 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.

26. Under the Certainty equivalent method, NPV is calculated as-

27. 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.

28. Exercise Vazeer Hydraulics is considering an investment proposal involving an outlay of Rs. 45,00,000. The expected cash flows and certainty equivalent coefficients are- The risk free interest rate is 5%. Calculate NPV of the proposal.