PROJECT APPRAISAL

UNDER RISK AND

UNCERTAINITY

Risk management

Risk management is concerned with identifying risks and drawing up plans to

minimize their effect on a project.

A risk is a probability that some adverse circumstances will occur:

Project risks affect schedule or resources;

Product risks affect the quality or performance of the software being
developed;
Business risks affect the organization developing or procuring the software.

The Risk management process

The risk management process :

Risk identification: Identify project, product and business risks;

Risk analysis: Assess the likelihood and consequences of these risks;

Risk planning: Draw up plans to avoid or minimize the effects of the risk;

Risk monitoring: Monitor the risks throughout the project.

Identify risk

Human from individuals or organizations, illness, death, etc.

Operational from disruption to supplies and operations, loss of

access to essential assets, failures in distribution, etc.

Reputational from loss of business partner or employee

confidence, or damage to reputation in the market.

Procedural from failures of accountability, internal systems

and controls, organization, fraud, etc.

Project risks of cost over-runs, jobs taking too long, of

insufficient product or service quality, etc.

Financial from business failure, stock market, interest rates,

unemployment, etc.

Technical from advances in technology, technical failure, etc.

Natural threats from weather, natural disaster, accident,

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disease, etc.

Risk planning

A formal project risk management plan is a detailed

plan of action for the management of project risk.
Project risk planning involves the thoughtful
development, implementation, and monitoring of
appropriate risk response strategies. It is the process to
develop and document an organized, comprehensive,
and interactive risk management strategy; determine
the methods to be used to execute a risk management
strategy; and plan for adequate resources.

Risk planning Consider each risk and develop a strategy

to manage that risk.

Avoidance strategies

Mitigation strategies

Contingency plans

Risk Analysis
Risk Analysis is one of the most complex and slippery aspect of capital Budgeting.
Techniques suggested to handle risk in capital budgeting fall into two broad
categories:

Techniques that consider the stand alone risk of a project

Techniques that consider the risk of a project in the context of firm and in
the context of market.

Sources of Risk
There are Several Sources of risk in a project. The important ones are:

Project Specific risk

Competitive risk

Industry specific risk

Market risk

International risk

Sensitivity Risk
Since the future is uncertain you may like to know that what will happen to the
viability of the project when some variables like sales or investment deviates
from its expected value.

The purpose of a sensitivity analysis is to understand how variances in such

things as benefits, costs, and other components of value affect. More
specifically, a sensitivity analysis will show the change in NPV , where key
inputs vary over a range of values. The benefit of conducting this analysis is
that it helps to reveal the variables that have greatest influence over the
potential success

It should be calculated using a change in projects NPV measured either at

financial or economic prices or both.

Example of Sensitivity analysis

Project A

Project B

Investment

50,000

50,000

Cash inflow for 5 years

Optimistic

30,000

Expected/ Most Likely

Pessimistic

40,000

20,000
15,000

20,000
5,000

The cut-off/ Discount Rate is 15%

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Strategies for responding to Risk

Avoid Risk

Transfer Risk

Mitigate Risk

Accept Risk

Research Risk

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What are the weaknesses of

sensitivity analysis?

Does not reflect diversification.

Says nothing about the likelihood of change in a

variable, i.e. a steep sales line is not a problem if
sales wont fall.

Ignores relationships among variables.

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Why is sensitivity analysis useful?

Gives some idea of stand-alone risk.

Identifies dangerous variables.

Gives some breakeven information.

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Sensitivity Analysis
Projects do not always run to plan. Costs and benefits estimated at an early
stage of a project may indicate a profitable project, but this profit could be
eroded by an increase in costs or a decrease in the value of the benefits (the
revenue).
Sensitivity analysis provides a means of determining the financial impact of
this type of fluctuation.
By entering an anticipated percentage increase in costs or decrease in
revenue the financial impact on the project can be identified by looking at the
change to the NPV or IRR measures.

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