Project Risk Analysis Part I

Project Risk refers to the variability in a project’s NPV. The term ‘risk’ is used in describing an investment whose cash flows are not known in advance with absolute uncertainty, but for which an array of alternative outcomes and their probabilities are known.

If there is greater variability, then the risk is higher and if there is lower variability, then the risk is lower.

There are two terminologies; Risk and Uncertainty, which are different though complementary subject. Risk refers to a situation where a project has a number of possible alternative outcomes but the probability of each occurring is known. Whereas Uncertainty refers to a situation in which these probabilities are not known. In practice, the terms are used interchangeably. To insist on the separateness of meaning of these terms would perhaps be slightly legalistic. When we call an investment risky, it means that we are uncertain about the future outcome of the investment in practice.

Origin/ Sources of Project Risk:

There are various factors to be considered that result in the uncertainty or risk involved in the analysis of the future economic consequences of an engineering project. Although all potential factors could not be listed out, some major sources of Project Risk are as follows:

1. Possible error of the cash flow estimates used in the study
2. Type of business involved in relation to the future health of the economy
3. Length of the study period used in the analysis
4. Type of physical plant and equipment involved

Methods of describing project risk:

We can analyze project risk by first determining the uncertainty inherent in a project’s cash flow. The analysis can be made in numerous ways ranging from making informal judgments to calculating complex economic and statistical analysis. Some of the methods of Project risk which we will be discussing are Sensitivity Analysis, Break Even Analysis, and Scenario Analysis.

1. Sensitivity Analysis:

It is one of the ways to gather a sense of the possible outcomes of an investment in a project. This analysis determines the effect of variations in the input variables such as salvage value, useful life, operating cost, revenues, etc. on the Net Present Worth (NPW) which is used to estimate the after-tax cash flows. Besides NPW, other criteria such as NFW (Net Future Worth), NAW (Net Annual Worth), IRR (Internal Rate of Return) and BCR (Benefit-cost Ratio) can also be considered in the sensitivity analysis which will change in response to a change in an input variable. During calculation, some variables have a comparatively greater influence on the final result than others.

In engineering economic studies, sensitivity analysis is a general non-probabilistic methodology to provide information about the potential impact of uncertainty in preferred factor estimates.

Steps for sensitivity analysis:

1. Begins with the base case situation considering the most likely values for each input.
2. Change the specific variable of interest by several specific percentages above and below the most likely value, keeping other variables constant.
3. Calculate a new PW (or FW/ AW/ IRR / BCR) for each values
4. Plot the results in sensitivity graph

In the graph, X-axis represents the uncertainty in input variable and Y-axis measures the impact of that uncertainty in the PW.

Fig: Sensitivity Graph of change in PW with change in different random variables

The slope of the line in the graph shows how sensitive the PW is to the change in each of the input variables. The steeper the slope, the more sensitive the PW is to a change in a particular variable. The plotted graph also determines the limits of uncertainty for each cash flow element.

2. Break Even analysis:

This analysis is one of the most common tools to evaluate the economic feasibility of a product. The main objective of Break Even Analysis is to find out the condition of no loss and no gain. That means the net PW or AW will be equal to zero. Break Even point is the point (number of sales units) at which revenue is exactly equal to costs.

To determine the breakeven point of a single project, we consider the fixed cost (FC) and variable cost per unit ‘V’ incurred in the project.

Let ‘S’ be the selling price per unit and ‘Q’ be the quantity of production or number of sales units.

Total sales or revenue = S×Q

Total cost = FC + V×Q

To get the breakeven point (intersecting point), we equate Total cost and Total revenue

Thus, S×Q = FC + V×Q

or, Q_BEP = FC/ (S – V)

Fig: Break Even Analysis

Break Even point is the lower limit of profit when price are set and margins are determined.

Similarly in another way, Break Even Analysis study the effects of change in output at project’s NPW or other measures like AW based on the project’s cash flows.

We compute the PW of cash inflows and outflows as a function of unknown variable ‘x’ perhaps annual sales.

PW of cash inflows = f(x)₁

PW of cash outflows = f(x)₂

Now we look forward for break even value of ‘x’ equating the inflows and outflows.

i.e. f(x)₁ = f(x)₂

3. Scenario Analysis:

Both the breakeven and sensitivity analyses have limitations that they cannot give the right relations when input variables are interdependent.

A scenario analysis displays the sensitivity of NPW with respect to changes in important variables to the range of likely values of the input variables. The decision maker can have the worst case scenario, most likely and the best case scenario. Then these scenarios are compared to the base case value of NPV.

Worst case scenario has cash flows lower than expected whereas best case scenario has higher than expected. In scenario analysis, we estimate expected cash flows and asset worth under various scenarios with the commitment of getting a better sense of the effect of risk on value.

Example of scenario analysis:

BIBLIOGRAPHY:

Chan S.Park, Contemporary Engineering Economics, Prentice Hall, Inc.
E. Paul De Garmo, William G.Sullivan and James A. Bonta delli, Engineering
Economy, MC Milan Publishing Company.
James L. Riggs, David D. Bedworth and Sabah U. Randhawa,Engineering
Economics, Tata MCGraw Hill Education Private Limited.