Project Management

A Managerial Approach

Risk Analysis

RISK ADJUSTED DISCOUNT RATE

The risk adjusted discount rate method calls for adjusting the discount rate to reflect the project risk. If the risk of the project is equal to the risk of the existing investments of the firm, the discount rate used is the average cost of capital of the firm. If the risk of the project is greater than the risk of the existing investments of the firm, the discount rate used is higher than the average cost of capital of the firm. Finally if the risk of the project is less than the risk of the existing investments of the firm, the discount rate used is less than the average cost of capital of the firm.

Risk adjusted discount rate is-

rk i n d k
where

rk
dk

=risk adjusted discount rate

i= risk free rate of interest

n= adjustment for the firms normal risk

=adjustment for the differential risk of the project

At NPV tI t 1 (1 rk )
Once the projects risk adjusted discount rate is specified, the project is accepted if NPV, calculated as follows is positive.

The Certainty Equivalent method is conceptually superior to the risk adjusted discount rate method because it does not assume that risk increases with time at a constant rate. Each years certainty equivalent coefficient is based on the level of risk characterizing its cash flow. Despite its conceptual soundness it is not as popular as the risk adjusted discount rate method.

This is perhaps because it is inconvenient and difficult to specify a series of certainty equivalent coefficients but seemingly simple to adjust the discount rate. Notwithstanding this practical difficulty, the merits of the certainty equivalent method must not be ignored.

SENSITIVITY ANALYSIS

THIS WORKS SIMILAR TO PERT ANALYSIS---an expected value for the main inputs to the project is put into the calculations of the outcome including an optimistic( +n%) & pessimistic (-n%) value ( the value of n is often 10). This will show the effect of a change in the variables considered on the outcome and can show where management control attention should be focused.

Example The price of materials & labour for a project is likely to fluctuate Contract price needs to be fixed in advance. Material is one of the major contributors to the cost of the project. Overheads are calculated as 175% of direct labour. Costs: material -$ 0.60 Direct labour- $0.20 Hence contribution to overheads- $0.35 Revenues: fixed at1.2$

The calculations carried out in the table are as follows:

Revenue material costs- combined labour & overhead costs =profit

MATERIALS

-10%
-10%
1.2-0.540.495 = +0.165 0.55 = +0.11

EXPECTED +10%
1.2-0.6-0.495 = +0.105 1.2-0.6-0.55 = +0.05 1.2-0.6-0.605 = -0.005 1.2-0.66-0.495 = +0.045 1.2-0.66-0.55 = -0.01 1.2-0.66-0.605 = -0.065

expected 1.2-0.54-

+10%

1.2-0.540.605 = +0.055

As can be seen , the effect of the changes in costs means that although on initial inspection this looks viable, the figures indicate that should materials increase by 10%, unless there is a drop in the labour costs of the project, it will make a loss.

Advantages of Sensitivity Analysis

It shows how robust or vulnerable the project is to changes in the values fo the underlying variables It indicates how sensitive is NPV to various factors and how the variability of these factors is to be contained It is intuitively very appealing.

Game Theory

Game theory

Concerned with the study of decision making in situations where 2 or more rational opponents are involved under conditions of competition and conflicting interests.

Game theory attempts to mathematically capture behavior in strategic situations, where an individual's success in making choices depends on the choices of others. While initially developed to analyze competitions where one individual does better at another's expense ZERO SUM GAMES, it has been expanded to treat a wide class of interactions, which are classified according to several criteria

A game consists of a set of players, a set of moves (or strategies) available to those players, and a specification of payoffs for each combination of strategies.

For e.g., candidates for election,advertising& marketing campaigns by competing business firms,countries involved in military battle etc.all have conflicting interests. In a competitive situation the courses of action(alternatives) for each competitor may be finite or infinite. IT CAN BE A 2-PERSON GAME OR AN n- PERSON GAME DEPENDING ON THE NO. OF PLAYERS.

In game theory zero-sum describes a situation in which a participant's gain or loss is exactly balanced by the losses or gains of the other participant(s). It is so named because when the total gains of the participants are added up, and the total losses are subtracted, they will sum to zero. Zero-sum can be thought of more generally as constant sum where the benefits and losses to all players sum to the same value. Cutting a cake is zeroor constant-sum because taking a larger piece reduces the amount of cake available for others. In contrast, non-zero-sum describes a situation in which the interacting parties' aggregate gains and losses is either less than or more than zero. The sum of a negative and a negative always equal a negative.

Some facts

A competitive situation is called a GAME if there are finite no. of competitors/players. Each player has a finite no. of strategies/alternatives available to him A play of the game takes place when each player employs his strategy Every game results in an outcome e.g., loss or gain or a draw, usually called PAYOFF.

Some facts

PURE STRATEGY-players select the same strategy each time. Player knows exactly what the other player is going to do. Objective of the players is to maximize profit or to minimize losses. MIXED STRATEGY-when the players use a combination of strategies and each player always keeps guessing as to which course of action will be selected by the other player. OPTIMUM STRATEGY-a course of action which puts the player in the most preferred position, irrespective of the strategies of the competitors.

VALUE OF THE GAME-expected payoff of play when all players of the game follow their optimum strategies. The game is fair if value is 0, else unfair. PAYOFF MATRIX: gains or losses can be represented in the form of a matrix called the PAYOFF MATRIX. In a ZERO SUM GAME-GAIN OF ONE PLAYER IS EQUAL TO THE LOSS OF THE OTHER, & vice versa.

Hence it is sufficient to construct a payoff matrix only for one player. LET aij be the payoff which player A gains from player B if A chooses strategy Ai and B chooses Bj. Then the payoff matrix to player A is (payoff matrix for B is aij)
pl.B
B1 B2 Bn

pl A

a A2 a Am a
A1

11

21

m1

a a a
12 22 m 2

a a a

1n

2 n

mn

EXAMPLE :CONSIDER 2 PEOPLE TOSSING A COIN. The game is ---B pays Rs. 7 to A if (H,H) occurs & Rs. 4 if (T,T) occurs; otherwise A pays Rs.3 to B. As payoff matrix may be displayed as below:

Pl B
H H 7 -3 T -3 4

player A
T
With the MAXIMIN- MINIMAX principle for the selection of the optimal strategies by the two players,saddle point where maximin value = minimax value, is found & the corresponding strategies are called OPTIMUM STRATEGIES. The amount of payoff is called the value of the game.

EXAMPLE:

Pl. B
B1 A1 9 B2 2

Pl. A

A2
A3

8
6

6*+
4

In symbols: maxi.(minj.(aij))= 6= minj.(maxi(aij)) Where i=1,2,3 & j = 1,2 RULES FOR DETERMINING SADDLE POINT:

Select the min. element of each row & mark *

Select the greatest element of each column & mark +. If there appears an element having both the marks, that is the saddle( equilibrium) point

Exercise 1

Two leading firms-Nirmala Textiles Ltd. And Aditi Rayon ltd, for years have been selling shirting, which is but a small part of both firms total sales. The marketing Director of Nirmala Textiles raised the question-What should the firms strategies be in terms of advertising for the product in question? The systems group of Nirmala Textiles developed the following data for varying degrees of advertising.

No advertising, medium advertising, heavy advertising for both firms will result in equal market share. Nirmala Textiles with no advertising: 40% of the market with medium advertising by Aditi Rayons and 28% of the market with heavy advertising by Aditi Rayons. Nirmala Textiles using medium advertsing:70% of the market with no advertising by Aditi Rayons and 45% of the market with heavy advertising by Aditi Rayons. Nirmala Textiles using heavy advertising: 75% of the market with no advertising by Aditi Rayons and 52.5% of the market with medium advertising by Aditi Rayons. Based on the above information, answer the marketing directors question.

Solution:
Aditi Rayons Strategy

No advtg
b1 a1 a2

Med advtg
b2

Heavy advtg
b3

Row min

Nirmala Textiles Strategy No advt Med advt

Hvy advt a3 Col Maxima

Solution:
Aditi Rayons Strategy

No advtg
b1 a1 a2 50 70 75 75

Med advtg
b2 40 50 52.5 52.5

Heavy advtg
b3 28 45 50* 50

Row min

Nirmala Textiles Strategy No advt Med advt

28 45 50

Hvy advt a3 Col Maxima

Solution contd.

Saddle point exists at the intersection of a3 and b3. Thus optimal strategy for each one is to engage in heavy advertising and it will result in an even distribution of the market between the firms. Nirmala Textiles marketing director should therefore resort to heavy advertising.

Exercise 2
Two bakeries in a city, IB Ltd. & HA Ltd. Are the only suppliers of bread & other bakery products to the city. With an increase in demand for their products, each has plans for future activities, such as not to expand production, change the present size of the bakery or to open a branch depot in the suburb. The payoff to the IB Ltd. In terms of % gain/loss is given as follows.

HA Ltd.

no expansion
0 25

Increase present capacity

-5 0

Open depot
-15 -10

1. No IB Ltd. expansion 2. Increase present capacity 3. Open a depot

15

10

Determine the optimal strategy for the two companies

Exercise 3

Shruti Ltd has developed a sales forecasting function for its products and the products of its competitor, Purnima Ltd. There are four strategies S1, S2, S3 and S4 available to Shruti Ltd and 3 strategies P1, P2, P3 to Purnima Ltd. The payoffs corresponding to all the twelve combinations of the strategies are given below. From the table we see that if S1 is employed by Shruti Ltd and P1 by Purnima Ltd., then there can be a gain of 30,000 in quarterly sales to the former. Other entries can be similarly interpreted. Considering this information what would the optimal strategy for Shruti Ltd. Be?

P1

P2

P3

Purnima Ltd Shruti S1

Ltd
S2

30,000 18,000 S3 S4 -6,000 18,000

-21,000 1,000 14,000 28,000 6,000 12,000 4,000 2,000