Managing Project Risks

Prof M V Monica
mvmonica@ibsindia.org
http://www.solutionsxgen.blogspot.com/
Managing Project Risks

Create Value in Project Finance

 Risks in Projects
• Essar Oil Ltd? Started along with RPL,
MRPL could finally go on stream by Nov
2007 only
• BSES Thermal Power Plant (Reliance
taken over) facing litigation for
Environmental Pollution finally paying
Rs.300 crores to farmers of Dahanu
Village, 150 km from Mumbai
 Recall: Nature of Projects
• Very huge outlay
• Very long gestation period
• Wider Impact –PEST:
• Irreversible : Funding is sans recourse &
so linked to the fortunes of the Project
• Smaller inflows from large number of
beneficiaries spread across generations
 Risks in Projects
• Completion risks – not getting completed on time and
cost limits
• Financing risks – arising out of capital structure/cash
flows associated with the project
• Operating & technology risks – inability to perform at the
production level within the design parameters on a
sustainable basis.
• Market risks – insufficient demand
• Counter-party risks – associated constituents not able to
meet their part of the job
• Political & regulatory risks – transparency and
predictability of regulatory commissions
• Force majeure risks – how do these clauses protect in
the event of natural calamities/ un – anticipated events
 Project Finance Credit Risks Overview

Force Majeure Political Contractual Financial

Events Risks Risks Risks
Natural War & Civil Civil Creeping Commercial Market
Disaster Disturbances Movements Expropriation Risks Risks
• Fire • Strike • Environment • Corruption • Construction • Interest rate
• Flooding • Insurrection • Human rights • Legal/regulatory • Facility site • Exchange rate
• Earthquake • Terrorism • CSR -irregularities • Equipment • Inflation rate
• Volcano • War • Religion • License/Permit • Technology • Labor cost
• Disease Outright • Nationalism • Concession • Off-take • Product market
Expropriation• Globalization • Taxes • Input • Input market
• Equity-holding • Operation • Salvage cost
• Expropriation
• Currency • Utility
• Confiscation
-inconvertibility • Collateral
• Nationalization
• Expatriation • Mineral reserves
• Preemption/priority• Reporting accuracy
• Breach of contract
• Foreign worker limitation
• Law enforcement
 Mechanism of Political Risks for PF
• Political shift
• Corruption
Weaker • Violation of law
Irreversible
negotiating • High profit
Investment
power • Rival company Creeping
expropriation
A large Easily attract
Political
standing out people’s
interest
asset attention Civil
Potential movement
foreign Trigger
exploitation
War/civil
Natural disturbance
Potentially high Civil
resources/
utility bills interest
infrastructure
• Natural disaster
Outright
Potential
• Environmental problem expropriation
environmental • Increased input costs
damage • Inefficient operation
• International relation
 Recall: Cost Analysis

Project D
Project C
Project B
Project A
2000 2001 2002 2003 2004
 Recall: Cost Analysis
• The life of the project is usually longer
than one year, so capital budgeting
decisions consider revenues and costs
over relatively long periods.
 Recall: Cost Analysis
• Life-cycle costing accumulates revenues
and costs on a project-by-project basis.
• This accumulation extends the accrual
accounting system that measures income
on a period-by-period basis to a system
that computes cash flow or income over
the entire project covering many
accounting periods.
Project Impacts Value of the Firm
Investing and Balance Sheet
Financing Income Statement
Decisions

Analysis of Balance Ratio Cash Flow

Sheet Changes Analysis Analysis
Statement Liquidity Statement
of Sources and Activity
of Cash
Uses Leverage
Profitability Flows
of Funds

Evaluation of Firm’s Firm’s

Risk/Return Stock
Characteristics Price
 The Essar Oil …
• Original estimate was Rs 1600 crores at
the time of public issue in 1995.
• In 1997 it planned to increase its original
capacity from 9 mt pa to 10.5 mt pa. at
additional cost of Rs 465 crores
• commission on June 1999 postpone the
same to April 2000
• IDBI funded additional 221 crores
• and also put a technical officer on site to
monitor the implementation.
• The sponsor Ruia group has to sell off the
single buoy mooring port at Jamnagar to
Essar shipping to bring in additional funds.
• Cyclone of June 1999
• The Govt persuaded the DFIs to extend
funds to Essar steel for meeting FRN
obligations.
• The Pokran blasts foiled its dreams of
again accessing international market for
funds.
• The cash flows of Essar Oil Ltd came
under pressure as oil prices fell and there
was n’t much demand for drilling works.
•
• The NCD issued for raising funds for the
oil refinery was successively down graded
by the CRISIL in 2000 as Eassar Shipping
failed to tie up funds for building the
storage tank for the use of Essar Oil Ltd
• Essar Shipping Ltd was suffering cash
shortages as the freight business was also
not doing well due to slump in oil prices
• In 2001, the company drawn up a plan for
raising its capacity from 9 mt to 24 mt pa
at a total cost of Rs 9455.00 crores
changing the product mix also in the
process.
• Project management skills possessed like
the RPL was missing at Essar Oil Ltd
leading to time over runs
• DFIs were not happy with Essar’s
peacemeal approach to the Project
Financing
• Innovative financing structures also could
n’t be thought of like RPL taking into
consideration the kind of uncertainities
associated with refinery projects
• Stagnant B/s size
• Essar was forced to restrict outlay to Rs
6000 crores and output 10.5 mtpa
• Getting the financial closure for the re-
starting the works at the refinery pre-
occupied most of 2002.
• The restructuring of DFIs itself(ICICI ltd
became ICICI bank) was taking a lot of
time.
• In 2003, the NCD holders went to court
and a re-scheduling plan with approval of
the court put in place.
• In 2003, the Energy division was sold off
to Bin Jabr Group, Abu Dhabi.
• prolonged discussions (IDBI also became
IDBI bank in 2004) and internal process
clean-up during 2004,
• Eassar could raise ECB for $207 million,
EPC contract for restoring the refinery
• works got sail in 2005.
• 9mtpa capacity went on stream in
November 2006 at a project cost of Rs 10,
826.00 crores and then
• raised to 10.5 mt pa in May 2008.
 Essar Oil Ltd Jan1996-Oct 2007
80.00
Share Price on BSE

70.00

60.00

50.00

40.00

30.00

20.00

10.00

0.00
6 6 7 7 8 8 9 9 0 0 1 1 2 2 3 3 4 4 5 5 6 6 7 7
r -9 ct-9 r-9 ct-9 r-9 ct-9 r-9 ct-9 r-0 ct-0 r-0 ct-0 r-0 ct-0 r-0 ct-0 r-0 ct-0 r-0 ct-0 r-0 ct-0 r-0 ct-0
Ap O Ap O Ap O Ap O Ap O Ap O Ap O Ap O Ap O Ap O Ap O Ap O
 RPL

Acquisition of Const Started:1996 Capacity Escallation 1996 from

land: Dec 94 9 MMTPA to 18 MMTPA

Further capacity Escallation

Dec 1998 to 27 MMTPA

Commissioned
1999-2000
 MRPL
April 1991: approval for
setting up 3 MMTPA @
Rs.11.62 billion
Commissioning
postponed from 1992
due to cost escalations

Finally Commissioned in
1996 @Rs 23.93 billion

Capacity raised to 9
MMTPA addl cost Rs 37
billion
 4/
3
6/ 0/ 1

1000
2000
3000
4000
5000
6000

0
2 9
9/ 8/ 1 96
3 9
12 0/ 96
/2 19
3/ 4 /1 96
3 9
6/ 1/ 1 96
3 9
12 0/ 97
/3 19
3/ 1 /1 97
31 9
6/ / 1 97
3 9
9/ 0/ 1 98
3
12 0/ 998
/3 19
9
3/ 1 /1 8
3 9
6/ 1/ 1 98
3 9
9/ 0/ 1 99
3 9
12 0/ 99
/3 19
3/ 0 /1 99

Commn delayed from 1996 for Capacity

31 9

escalations 18 MMTPA and commi1999-

6/ / 2 99

Reliance Reineries Pvt Ltd-1991; Became

30 00

Public Ltd 1993;9MMTPA@Rs.51.42 Billion;

9/ / 2 0
12 29/ 000
/2 20
3/ 9 /2 00
3 0
6/ 0/ 2 00
2 0
9/ 9/ 2 01
2 0
12 8/ 01
/3 20
3/ 1 /2 01
2 0
RPL & MRPL STOCK PRICE

6/ 8/ 2 01
28 00
6/ / 2 2
2 0
9/ 8/ 2 02
30 00
9MMTPA in 1999 /2 2
00
2
0
10
20
30
40
50
60
70

billion;Comm:1996;Finally to
RPL
MRPL

be st up 1992 3 MMTPA@Rs.11.62
BSE-30

First Private Sector Refinery 1991;To

 How Risks are monitored?
Types of Analysis Types of Ratios Types of Analysis

Liquidity
Financial Manager
(Ability to meet
Short-Term Creditor
short-term obligations)
Cross Section
(Performance relative to Activity
other firms in the Financial Manager
(Efficiency of use of
industry)
resources)

Leverage Financial manager

(Extent of use and ability Long-Term Creditor
Trend to repay debt financing)
(Change in performance
over time) Profitability Financial Manager
(Ability to generate Stockholder
return on invested funds)
 Risk Analysis in Capital
Investment Decisions
• What is Risk
• Types of Risk
• Measurement of Risk
• Method of Incorporating Risk into Capital
Budgeting
 What is Risk?
• Possibility of an outcome being different
from what is expected.
 What is Risk

Certainty Uncertainty

Knowledge of Possible outcomes

exists;

But which alternative

will happen, is not sure;
but probability can be
determined
 Risk in Project Mgt
• Technical Risks • NO elimination!!
• Economic Risks • Ensure it does not
• Social Risks • have adverse
• Production Risks • consequences
• Financial Risks
• Human Risks • Pay compensation
least possible!?
 Types of Risks
• Business Risk • Financial Risk
variability of the
earnings due to Variability of the after tax
earnings or EPS of the firm
changes in the caused by financial structure
firm’s normal
operating conditions

Investment risk

Portfolio Risk
 Risk Mgt
Formal Process by which risk factors are
Systematically
• Identified
• Assessed and
• Provided for
 Decision Analysis
Decision Alternatives
• Your options - factors that you have control over
• A set of alternative actions - We may chose whichever we please

States of Nature
• Possible outcomes – not affected by decision.
• Probabilities are assigned to each state of nature

Certainty
• Only one possible state of nature
• Decision Maker (DM) knows with certainty what the state of nature will be

Ignorance
• Several possible states of nature
• DM Knows all possible states of nature, but does not know probability of
occurrence

Risk
• Several possible states of nature with an estimate of the probability of each
• DM Knows all possible states of nature, and can assign probability of
occurrence for each state
 Decision Making Under Ignorance
• LaPlace-Bayes
– All states of nature are equally likely to occur .
– Select alternative with best average payoff
• Maximax
– Evaluates each decision by the maximum possible return
associated with that decision
– The decision that yields the maximum of these maximum
returns (maximax) is then selected
• Maximin
– Evaluates each decision by the minimum possible return
associated with the decision
– The decision that yields the maximum value of the minimum
returns (maximin) is selected

• Minmax Regret
– The decision is made on the least regret for making that choice
– Select alternative that will minimize the maximum regret
LaPlace-Bayes
Strategy State of Nature LaPlace-
Demand Bayes
criterion
Low(50 Med(100 High(150 Mean
units) units) units)
Build 50 400000 400000 400000 400,000

Build 100000 800000 800000 566,667

100
Build (200000) 500000 1200000 500,000
150
 Maximax (Hurwicz criterion)

State of Nature
Maximax
Demand Criterion
Alternative
Actions
Low (50 units) Medium (100 units) High (150 units) Max

Build 50 400,000 400,000 400,000 400,000

Build 100 100,000 800,000 800,000 800,000

Build 150 (200,000) 500,000 1,200,000 1,200,000

 Maximin(Wald criterion)

State of Nature
Maximin
Demand Criterion
Alternative
Actions
Low (50 units) Medium (100 units) High (150 units) Min

Build 50 400,000 400,000 400,000 400,000

Build 100 100,000 800,000 800,000 100,000

Build 150 (200,000) 500,000 1,200,000 (200,000)

 MiniMax Regret table
Strategy State of Nature Regret
Demand Criterion
Low(50 Med(100 High(150 Max
units) units) units)
Build 50 No lose 400000 800000 800000

Build 300000 No lose 400000 400000

100
Build 600000 300000 No lose 600000
150
 Decision Making Under Risk
• Expected Return (ER) or Expected Value (EV) or Expected Monetary Value
(EMV)
– Sj The jth state of nature
– Di The ith decision
– P(Sj) The probability that Sj will occur
– Rij The return if Di and Sj occur
– ERj The long-term average return
• ERi =  Rij  P(Sj)
• Variance =  (ERi - Rij)2  P(Sj)

• The EMV criterion chooses the decision alternative which has the highest
EMV. We'll call this EMV the Expected Value Under Initial Information (EVUII)
to distinguish it from what the EMV might become if we later get more
information. Do not make the common student error of believing that the EMV
is the payoff that the decision maker will get. The actual payoff will be the for
that alternative (j) Vi,j and for the State of Nature (i) that actually occurs.
 Decision Making Under Risk
• One way to evaluate the risk associated with an Alternative
Action by calculating the variance of the payoffs. Depending
on your willingness to accept risk, an Alternative Action with
only a moderate EMV and a small variance may be superior
to a choice that has a large EMV and also a large variance.
The variance of the payoffs for an Alternative Action is
defined as
• Variance =  (ERi - Rij)2  P(Sj)

• Most of the time, we want to make EMV as large as

possible and variance as small as possible. Unfortunately,
the maximum-EMV alternative and the minimum-variance
alternative are usually not the same, so that in the end it
boils down to an educated judgment call.
 Expected Return

State of Nature
Expected
Demand Return
Alternative
Actions
Low (50 units) Medium (100 units) High (150 units) ER

Build 50 400,000 400,000 400,000 400,000

Build 100 100,000 800,000 800,000 660,000

Build 150 (200,000) 500,000 1,200,000 570,000

Probability 0.2 0.5 0.3 1.0

 Expected Value of Perfect Information

• EVPI measures how much better you

could do on this decision if you could
always know what state of nature would
occur.
 Expected Value of Perfect Information

• The Expected Value of Perfect Information

(EVPI) provides an absolute upper limit on the
value of additional information (ignoring the
value of reduced risk). It measures the amount
by which you could improve on your best EMV if
you had perfect information. It is the difference
between the Expected Value Under Perfect
Information (EVUPI) and the EMV of the best
action (EVUII).
 Expected Value of Perfect Information
• The Expected Value of Perfect Information
measures how much better you could do on this
decision, averaging over repeating the decision
situation many times, if you could always know
what State of Nature would occur, just in time to
make the best decision for that State of Nature.
Remember that it does not imply control of the
States of Nature, just perfect prediction.
Remember also that it is a long run average. It
places an upper limit on the value of additional
information.
 Expected Value of Perfect
Information
– EVUPI - Expected Value under perfect
information
 P(Si)  max(Vij)

– EVUII – EMV of the best action

max(EMVj)

– EVPI = EVUPI - EVUII

 Expected Value of Sample
Information
• EVSI = expected value of sample
information
• EVwSI = expected value with sample
information
• EVwoSI = expected value without sample
information

• EVSI = EVwSI – EVwoSI

• Efficiency Index = [EVSI/EVPI]100
 Why is decision-making so
complicated ?

• Most problems in project management

involve multiple objectives
• Project managers are always dealing with
uncertainties
• Project management problems may be
very complex
• Most projects include multiple
stakeholders
How Decisions Are Made?
No uncertainties – No
alternatives
No alternatives – No decisions

Two decision-making approaches:

Advocacy-based Decision Analysis

approach Process
 Do We Have a Solution?

Decision Analysis Process

Decision Science

Theory of Probability Psychology of

and Judgment and
Statistics Decision Making
 Human Judgment Is Always to
Blame
This study by Swiss Federal Institute of Technology in Zurich
analyzed 800 cases of structural failures where engineers were at
fault. In these incidents 504 people were killed, 592 injured and
millions of dollars of damage incurred.
• Insufficient Knowledge – 36%
• Underestimation of influence – 16%
• Ignorance, carelessness, neglect – 14%
• Forgetfulness – 13%
• Relying upon others without sufficient control – 9%
• Objectively unknown situation – 7%
• Other factors related to human error – 5%
 How Risks Measured?
• Range of NPV
• MAD
• Variance
• Semi-variance
• Standard deviation of NPV
 How Risks Analysed?

• Sensitivity analysis
• Scenario Analysis
• Simulation
• Decision tree