Amity Business School

Project Risk
 What is Risk Amity Business School

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 schedule-
obtaining LOI-conducting contour survey and
Benchmarking-Conducting investigation of
ground water-development of plot plan-
manpower-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 Amity Business School

• 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 Amity Business School
Category Project Risk Possibility of Occurrence
Resource Risk • Quantity of crude oil •Hired external agency, DeGolyer
• Right grade of crude oil to and MacNaughton to estimate
ensure the correct
functioning of upgradrer
project’s reserves
•Only 7% of estimated reserve is
required for project
(120,000*365*35)/21.5 = 7.1%
Technological • The drilling technology •External agency, Stone & Webster
and Conoco refining
Risk technology are proven
found design to be in accordance
to good industry practices

Timing and • 3 segments and complex •Stone & Webster found execution
Completion • Timely finish to realize schedule to be achievable
early project cash flows
Risk •Use of known technologies
• Use of local players
 Post-completion Risks
Category General Risk Amity Business School
Possibility of Occurrence

Market Risk • Price of oil is volatile •Chem Systems found the pricing to be
• Lack of established reasonable and consistent with market
market for syncrude
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 utilities are located in
by government or PDVSA
Venezuela •Post-completion, project would be
independent
Throughput • Simultaneous •Usage of known technologies and
functioning of 3
Risk components to
experienced participants
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 General Risk Possibility of Occurrence

Exchange Rate • Appreciation of •Between 1995 and 1996, Bolivar

Bolivar will increase
Risks local operating costs
depreciated over 64%
and tax liability

Currency • No exchange rate •Petrozuata has approval for an off-

control since 1996
Convertibility shore dollar denominated proceeds
and account
Transferability •PDVSA has similar account and has
Risk never defaulted on payments
Inflation Risk • High levels of •No possible remedy except favorable
inflation with nearly
100% in 1996
exchange rate movements
 Sovereign & Legal Risks
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Category General Risk Possibility of Occurrence

Expropriation • Nationalization of oil •Petrozueta is the first in a series of
industry in 1976
Risks planned projects to any failure of
• Forceful selling of
output to others than
government might hamper those
Conoco projects
• Diversion of payments •In case of diversions, it may be
against the revenue difficult to get new buyers as most of
waterfall agreement
these are located on US Gulf Coast
• Preferential tax and
royalty rate treatment 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

Legal System • Sovereign right to all •No possible remedy

oil assets resulting in
Risk no claim on debt
holders in case of
default
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Mitigation Strategies

• Insure

• Allocate

• Hedge

• Deter

• Bear
 Risk Classification Amity Business School

Macroeconomic Risk Financing Risk

(Exchange Rate Risk, Sovereign & Legal Risk
Interest Rate Risk, Macroeconomic Risk
Market Inflation) (Currency Convertibility and
Type of Risk

Demand Risk Transferability)

Construction Stage Risk
(Delays in getting permits/ land
Force Majeure acquisition, Cost/Time Overruns)
(Acts of God) Operational Stage Risk
Project Counterparty Risk (Demand and Supply Risk,
Management Risk, Environmental
Risk)

Low High

Ability to Control
 Agreements to Mitigate Risk
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• Financing Agreements

• Construction Agreements

• Sales or Off-take Agreements

• Supplies Agreements