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Project Risk

What is Risk

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The notion of the risk involves two concepts – likelihood and impact of future events The risk is defined as a function of the two as:

Risk = f (likelihood, impact)

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Why CapEx Project is Risky

• Unique – No Previous History • Huge Strategic Impact • Long Gestation Period • Large Number of Players

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Pre project Activities
• • • • • • • • Obtaining the clearance from competent authorities. Developing the required infrastructure. Arrangement of Raw Material. Arrangement of Technical know how. Arrangement of Finance. Identification of relevant markets. Identification of project/product. Identification of process licenser.

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Contd.
• Site selection-investment decision-Finalizing technical package-implementation scheduleobtaining LOI-conducting contour survey and Benchmarking-Conducting investigation of ground water-development of plot planmanpower-fabrication-construction workload forecast-recruitment. • -Ernest money---The amount to be deposited with tender document. • Retention money—is generally considered as a contractual safeguard and not as cheap form of finance…10% with order, 80%with completion,

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Advance activities
• • • • • • • • • • • • • • • Fencing /boundary walls. Development of approach road. Preliminary soil investigation. Agreement for power. Agreement for water. Sliding arrangement. Arrangement of Communication network. Site office development. Cement go down, Arrangement for transport system. Registration for Tax, co, law. Building house for staff and labor. Guest house, construction /school building. Infrastructure, equipment for construction. Drainage and sewage plan.

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Project Activities
• • • • Procurement of machinery and material. Transportation of Machinery and material. Civil works for site development/building. Fabrication/erection of structure, equipment and material. • Pre commissioning, trial run. • Performance test.

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Stages for Risk Identification
• Pre-operative Stage Risks – Development Stage Risks – Construction Stage Risk • Operational Stage Risks • Political Risks

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Development Stage Risks
• Development or Bid Risk • Ownership Risk---poison pill, shark repellant and white knight

Ownership Risk

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• Equity Partners Selection Risk • Capital Structure Risk
– Debt Equity Mix – Equity Mix

• Corporate Governance Structure Risk

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Construction Stage Risks
• Time Overrun Risk • Cost Overrun Risk • Performance Level Risk • Political Risk • Force Majeure – Political events – war, strikes, terrorism – Acts of God – hurricane, earthquakes

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Operational Stage Risks
• Economic Off-take/Market Risk • Input Related Risk • Counterparty Risk • Management Risk • Performance Related/Throughput Risk • Environmental Risk • Force Majeure • Financial Risk – Interest Rate Risk

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Financing/Refinancing Risk
• Acceptance for Mandate Risk • Credit Rating Risk • Subscription Risk • Timely Availability Risk • Change in Financing Plan

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• White knight---A friendly acquirer who, at the invitation of a target company , purchases shares from the hostile bidder or launches a friendly counter bid to frustrate the initial unfriendly bidder. • Shark repellent---Defenses employed by a company to ward off potential bidders-sharks. • Poison pill—A device used by a company to make itself less attractive as a takeover candidate , its poison , so as to speak, is released when the buyer takes a sufficient bite of the target firm.

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Development or Bid Risk
• Project Feasibility Related • Country Feasibility Specific • Bid Related

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• The strategies to manage risk include transferring the risk to another party, avoiding the risk, reducing the negative effect of the risk, and accepting some or all of the consequences of a particular risk. For the most part, these methodologies consist of the following elements, performed, more or less, in the following order. • identify, characterize, and assess threats • assess the vulnerability of critical assets to specific threats • determine the risk (i.e. the expected consequences of specific types of attacks on specific assets) • identify ways to reduce those risks • prioritize risk reduction measures based on a strategy

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• • • • • • • • • • • •

The International organization for standardization identifies the following principles of risk management: Risk management should create value. Risk management should be an integral part of organizational processes. Risk management should be part of decision making. Risk management should explicitly address uncertainty. Risk management should be systematic and structured. Risk management should be based on the best available information. Risk management should be tailored. Risk management should take into account human factors. Risk management should be transparent and inclusive. Risk management should be dynamic, iterative and responsive to change. Risk management should be capable of continual improvement and enhancement.

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Risk less rate
• There is no default risk. • There is no uncertainty about reinvestment rate. • Risk less rate when there is sovereign risk. • Total risk=====unique risk (firm specific) market risk

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Source of equity risk in a project
• Project risk---project may have higher or lower cash flows, either cash flows miscalculated or factors specific to the project effected cash flows. • Competitive risk. • Sector or industry risk 1….Technolology risk, 2---legal risk, 3---commodity risk. • International risk. like sovereign risk/FC Risk. • Demand risk. Force majeure risk, performance risk, operational risk, interest rate risk.

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Systematic/unsystematic or undiversifiable and diversifiable risk.

• Market risk, generated by macro economic factors, that essentially effect all projects to varying degrees, like interest rates. • Project risk can be diversified away both by firms when it invests in multiple projects and by investor when it invests in different firms.

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Company specific or environment specific

• Company specific to environment specific----project may do better or worse than expected.------competition may be stronger or weaker than expected.-----entire sector may be effected by action------exchange risk and political risk----interest rate, inflation and news about economy.

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Default risk
• Firms that generate high cash flows related to its financial obligations should have lower default risk. • Thus firms with existing cash flows will have lesser default risk. • More stability in the cash flows, lesser is the default risk.

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Managing risk
• Change the fixed cost/VC ratio---ford in 1980, outsourced component manufacturing which resulted in lower Fixed cost and lowering of breakeven point. • Lower price increases demand but increases breakeven point, so publishers bring hard cover edition first and then shift to soft cover.

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Cont.
• If you are not sure to market reaction to your product, start small , it may increase high cost of production per unit but reduces risk. • Don't test the depth of the water with both feet. • If the operating risk of the risk is high, go for low debt dependence. • Take insurance.

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Contd.
• Go for long term arrangements suppliers, employees , lenders, customers. • Strategic alliance like joint venture, contribute resources and core competence, work together with competitors as ET reports on 10th Aug that Spencer's, reliance, more etc are joining hands to reduce costs. • Derivatives and hedging.

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Risk analysis in Practice
• Conservative estimates of Revenues. • Safety margin in cost figures. • Flexible Investment yardsticks like uping the post tax returns. • Sensitivity analysis. • Scenario analysis/ • Breakeven analysis. • Decision tree analysis.

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Acceptable overall certainty index
• The overall certainty index for a capital expenditure considered by this firm was calculated for this firm • Certainty index(%) • Raw material availability 70 • Power availability 60 • Freedom from competition 80 • Overall certainty index=70+60+80/3=70,which was considered safe by the company.

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Abandonment value
• The value of a project, if the project’s assets were sold externally , or alternatively , its opportunity value if the assets were employed else where in the firm. • Managerial options include the option to expand, contract, , the option to abandon, and the option to postpone. Considering of these various options can sometimes turn a reject decision otherwise made in evaluating a capital budgeting project into a accept decision and a accept decision into a decision to postpone.

Pre-completion Risks
Category Resource Risk Project Risk

Possibility of Occurrence

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• Quantity of crude oil •Hired external agency, DeGolyer • Right grade of crude oil to and MacNaughton to estimate ensure the correct project’s reserves functioning of upgradrer

•Only 7% of estimated reserve is required for project (120,000*365*35)/21.5 = 7.1%

Technological Risk

• The drilling technology and Conoco refining technology are proven

•External agency, Stone & Webster found design to be in accordance to good industry practices •Stone & Webster found execution schedule to be achievable •Use of known technologies

Timing and Completion Risk

• 3 segments and complex • Timely finish to realize early project cash flows • Use of local players

Post-completion Risks
Category Market Risk General Risk
• Price of oil is volatile • Lack of established market for syncrude Amity Possibility of Occurrence Business School

•Chem Systems found the pricing to be reasonable and consistent with market developments and expected that a 3rd party market may develop

Supply/ Input • Labour, materials, •Most of the utilities were either owned part suppliers and Risk by government or PDVSA utilities are located in Venezuela •Post-completion, project would be independent Throughput Risk
• Simultaneous •Usage of known technologies and functioning of 3 experienced participants components to produce the syncrude •Engineers didn’t expect varying density • Varying density of to be a major problem crude effecting the efficiency

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Macroeconomic Risks
Category Exchange Rate Risks General Risk
• Appreciation of Bolivar will increase local operating costs and tax liability • No exchange rate control since 1996

Possibility of Occurrence •Between 1995 and 1996, Bolivar depreciated over 64%

Currency Convertibility and Transferability Risk Inflation Risk

•Petrozuata has approval for an offshore dollar denominated proceeds account •PDVSA has similar account and has never defaulted on payments •No possible remedy except favorable exchange rate movements

• High levels of inflation with nearly 100% in 1996

Sovereign & Legal Risks
Category Expropriation Risks General Risk
• Nationalization of oil industry in 1976 • Forceful selling of output to others than Conoco • Diversion of payments against the revenue waterfall agreement • Preferential tax and royalty rate treatment

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Possibility of Occurrence •Petrozueta is the first in a series of planned projects to any failure of government might hamper those projects •In case of diversions, it may be difficult to get new buyers as most of these are located on US Gulf Coast and may not be keen to enter into an agreement due to ramifications in the US •PDVSA has assets off-shore like CITGO in US •No possible remedy

Legal System Risk

• Sovereign right to all oil assets resulting in no claim on debt holders in case of default

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Mitigation Strategies
• Insure • Allocate • Hedge • Deter • Bear

Risk Classification
Type of Risk
Macroeconomic Risk (Exchange Rate Risk, Interest Rate Risk, Inflation) Market Demand Risk

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Financing Risk Sovereign & Legal Risk Macroeconomic Risk (Currency Convertibility and Transferability) Construction Stage Risk (Delays in getting permits/ land acquisition, Cost/Time Overruns) Operational Stage Risk (Demand and Supply Risk, Management Risk, Environmental Risk)
High

Project

Force Majeure (Acts of God) Counterparty Risk

Low

Ability to Control

Agreements to Mitigate Risk

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• Financing Agreements • Construction Agreements • Sales or Off-take Agreements • Supplies Agreements