Project Risk

Corporate Finance

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Importance of Risk Analysis
There are two fundamental reasons to perform risk analysis
before making a final accept/reject decision:
• Project cash flows are risky and may not be equal to the
estimates used to compute NPV.
• Forecasts are made by humans who can be either too
optimistic or too pessimistic when making their cash flow
forecasts. Risk analysis will help guard against such biases.

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Importance of Risk Analysis contd..
• It is reasonable to assume that the actual cash flows an
investment produces will never equal the expected cash flows
used to estimate the investment’s NPV as there are many
possible cash flow outcomes for any project.

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 Uncertainty may due to…
• Economic conditions -- Will consumers be spending or saving? Will the
economy be in a recession? Will the government stimulate spending? Will
there be inflation?
• Market conditions -- Is the market competitive? How long does it take
competitors to enter into the market? Are there any barriers, such as
patents or trademarks that will keep competitors away? Is there sufficient
supply of raw materials and labor? How much will raw materials and labor
cost in the future?
• Taxes -- What will tax rates be? Will Government alter the tax system?
• Interest rates -- What will be the cost of raising capital in future years?
• International conditions -- Will the exchange rate between different
countries' currencies change? Are the governments of the countries in
which the company does business stable?

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Project Risk Management
• Tools such as Sensitivity analysis, Scenario analysis, and
Simulation analysis provide better understanding of the
uncertainty of future cash flows and, consequently, the
reliability of the NPV estimate.

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Expected Values
– The expected value of a future cash flow is given
by the probability weighted average of all the
possible cash flows that might occur.
– The cash flows used to calculate a project’s NPV
are expected values.

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Sensitivity analysis
• Sensitivity analysis occurs when a financial manager
evaluates the effect of each value driver on the investment’s
NPV.
• It helps identify the variable that has the most impact on NPV.

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Sensitivity Analysis
• Shows how changes in a variable such as unit sales affect NPV
or IRR.
• Each variable is fixed except one. Change this one variable to
see the effect on NPV or IRR.
• Answers “what if” questions, e.g. “What if sales decline by
30%?”

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 Sensitivity Analysis

• Allows us to look behind the NPV number to see how

firm our estimates are.
• When working with spreadsheets, try to build your
model so that you can just adjust variables in one cell
and have the NPV calculations key to that.

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Sensitivity Analysis: An Illustration
Caselet - pharmaco

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Weaknesses and strengths
Weaknesses
• Says nothing about the likelihood of change in a variable, i.e.
a steep sales line is not a problem if sales won’t fall.
• Ignores relationships among variables.
Strengths
• Identifies dangerous variables.
• Gives some breakeven information.

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Scenario Analysis
• Sensitivity analysis involves changing one value driver at a
time and analyzing its effect on the investment NPV.

• Scenario analysis considers the effect of multiple changes in

value drivers on the NPV. For example, the scenarios could be
Expected or base-case, Worst-case and Best-case.
Scenario Analysis

• For example, the following three scenarios could apply be evaluated:

1. Best
2. Worst
3. Normal

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Weaknesses
• Only considers a few possible out-comes.
• Assumes that inputs are perfectly correlated--all “bad” values
occur together and all “good” values occur together.
• Focuses on stand-alone risk, although subjective adjustments
can be made.

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Monte Carlo simulation
• Monte Carlo simulation of capital budgeting projects is often
viewed as a step beyond either sensitivity analysis or scenario
analysis.
• Interactions between the variables are explicitly specified in
Monte Carlo simulation, consequently, this methodology
provides a more complete analysis.

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Monte Carlo simulation
• An approach that allows us to test the possible results of an
investment proposal before it is accepted. Testing is based on
a model coupled with probabilistic information.

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Factors we might consider in a model
Market analysis
• Market size, selling price, market growth rate, and market
share
Investment cost analysis
• Investment required, useful life of facilities, and residual value
Operating and fixed costs
• Operating costs and fixed costs

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Monte Carlo simulation
• Involves making assumptions about the shape of each future
cash flow
• A computer is used to quickly determine random
observations for each uncertain cash flows and determine
numerous possible outcomes (1000s)
• Computer then simulates project by constructing a probability
distribution of the project's NPV (IRR)

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Procedure
• Choose critical variables
• Replace the EVs with distributions
– Discrete
– Continuous
• Choice depends on range of feasible outcomes for the
variables and past experience of the company
• Estimate the parameters of the distribution
• Run simulation
• Summarize the results

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Questions that can be answered
• What is the likelihood of NPV > 1000?
• What is the likelihood of NPV < 0?
• What are the worst and best cases? Their Prob?
• What is the riskiness of this project vis-à-vis other projects?

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Advantages of simulation analysis
• Reflects the probability distributions of each input.
• Shows range of NPVs, the expected NPV, σNPV, and CVNPV.
• Gives an intuitive graph of the risk situation.

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Disadvantages of simulation?
• Probability distributions have to be estimated subjectively
• Project cash flows tend to be positively correlated—hard to
estimate the extent of that correlation
• Interpretation of results is subjective
• If inputs are bad, output will be bad:
“Garbage in, garbage out.”

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Decision tree
• A chronological depiction of the alternatives in a simple
graphical manner displaying all the interrelationships among
choices and uncertainties.
More suitable when:
• Alternatives
• Uncertainties
• Objectives
Decision Trees

• Decision trees are most beneficial when a

sequence of decisions must be made
• All decision trees contain decision points or nodes
and state-of-nature points or nodes
– A decision node from which one of several alternatives
may be chosen
– A state-of-nature node out of which one state of
nature will occur

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Five Steps to Decision Tree Analysis

1. Define the problem

2. Structure or draw the decision tree
3. Assign probabilities to the states of nature
4. Estimate payoffs for each possible combination
of alternatives and states of nature
5. Solve the problem by computing expected
monetary values (EMVs) for each state of
nature node

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Some convention

A decision node – in the hands of the decision maker

A chance event – not in the control of the Dmaker

An outcome
 Win

Make a proposal

Succeed Lose

Don’t make
Continue
Win

Make a proposal

Fail Lose

Don’t make

Abandon
What next?
• Maximize EMV
• Ascertain the net cashflows at each end point
Lets formalize the procedure

Begin at the right

end points

Replace it with the Max() or Min() of the EMV

Replace it with the EMV

Move back until reaching the initial node

Example
• Imagine that you have to advise a company on whether to
build an automatic plant or a manual plant.
• The NPVs of the plants depend on whether the demand will
be high/moderate/low. Accordingly, they are estimated as:

High Moderate Low

Automatic 200 60 -30
Manual 140 80 20
Prob 0.3 0.4 0.3

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• On top of this information, the company can also conduct a
feasibility study to get more information.
• The study can report either favourable market conditions
exist or vice versa.
• The cost of study is 10.
• You also have the following probabilities:
Pr(F) = 0.40 Pr(U) = 0.60
Pr(H!F) = 0.45 Pr(H!U) = 0.20
Pr(M!F) = 0.40 Pr(M!U) = 0.40
Pr(L!F) = 0.15 Pr(L!U) = 0.40

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Let me remind you
• Decision making is an iterative process
• Dtrees if applied carefully can’t make a hard decision easy but
they will certainly make the process easier
• A wise decision requires judgment, creativity as well as
technical proficiency