Chapter-8 Risk Management

Transcription

1 Chapter-8 Risk Management 8.1 Concept of Risk Management Risk management is a proactive process that focuses on identifying risk events and developing strategies to respond and control risks. It is not a one-time event carried out at the beginning of a project. It may be defined as an art and science of identifying, assigning, and responding to risk throughout the life of a project. It can often result in significant improvements in the ultimate success of projects. Risk management can be applied to: Selecting project Determining project scope Developing schedules Developing cost estimates Risk management helps stakeholders understand the nature of the project, involves team members in identifying strengths and weaknesses and helps to integrate the other projects management knowledge areas. It is a critical process in project management, which is not often conducted or handled well. It allows the project manager to view the project across the life cycle to identify, assess, prioritize, respond to and control project risk. Effective risk management increases the probability of project success by the following efforts: Preventing surprises / problems Preventing management by crisis Improving customer/ stakeholder satisfaction Increased profitability and competitive advantage. Project Management Institute (PMI TM ) in the Project Management Body of Knowledge (PMBOK TM ) defines risk management as the systematic process of identifying, analyzing, and responding to project risk. It includes maximizing the probability and consequences of positive events and minimizing the probability and consequence of adverse events to project objectives. A risk management may be shown as under: Project objectives, goals Requirements definition Project baseline Risk management WBS development established & project scope Estimates & schedule development Lecturer in Finance, DBA, IIUC, Website: 1

2 8.2 Classification of Risk: Usually four categories of risk found in managing project, which are as follows: Business risk: Normal risk of doing business that carries opportunities for both gains and losses. It occurs as a result of business decisions such as the decision to use a new technology in a project to leverage future business opportunities. Insurable risk: Risk that presents and opportunity for loss only. For this type of risk you could purchase insurance premium. Insurable risk is also known as pure risk. Known risk: Risks that were identified for a particular project. Unknown risk: Risks that were not identified or managed, unknown risk if they occur on a project and found positive are called windfalls. 8.3 Sources of Risk in Projects: A number of studies have shown that projects share some common sources of risk. In 1996 the Standish Group developed 1 the following top ten success criteria for information technology projects based on interviews with 60 IT professionals (weights indicate relative importance). The same concept is true across business projects within organizations: Success criteria / sources of risk Weight (%) User involvement 19 Executive management support 16 Clear statement of requirements 15 Proper planning 11 Realistic expectations 10 Smaller project milestones 9 Competent staff 8 Ownership 6 Clear visions and objectives 3 Hard-working, focused staff 3 Total 100 Broad categories of risk include: Market risk: Will the project product be marketable and competitive? Financial risk: Is the project affordable and will it provided the expected ROI? What about opportunity cost? Could the money be better spent elsewhere? Technology risk: Is the project technically feasible? Will the technology meet project objectives? Will the technology be obsolete before the product is produced? The PMI has a specific interest group on risk management. You can check out their website at Lecturer in Finance, DBA, IIUC, Website: 2

3 8.4 Risk Management Process The PMBOK TM provides and overview of the process as follows: Risk management planning: Deciding how to approach and plan the risk management activities for a project. Risk identification: Determining which risks might affect the project and documenting their characteristics. Qualitative risk analysis: Performing a qualitative analysis of risks and conditions to priorities their effects on project objectives. Quantitative risk analysis: Measuring the probability and consequences of risks and estimating their implications for project objectives. Risk response planning: Developing procedures and techniques to enhance opportunities and reduce threats to the project s objectives. Risk monitoring and control: Monitoring residual risks, identifying new risks, executing risk reduction plans, and evaluating their effectiveness throughout the project life cycle. All processes interact with each other and with all knowledge areas within the PMBOK. The PMBOK also defines inputs, tools & techniques and outputs for each of the process identified within risk management. The process description for risk management is depicted as under: Risk identification Risk analysis o Qualitative o Quantitative Risk response development Risk response control o Implement strategy Evaluate results Document results The following diagram depicts a standard risk management process: Risk Management Process Identify risks Assess risks Develop risk response Document Evaluate Execute risk results results management plan Lecturer in Finance, DBA, IIUC, Website: 3

4 The above diagram displays that risk management is conducted as a continuous process throughout the entire project life cycle. Planning and execution are continuous events. The major issues of risk management process have been elucidated below: Risk identification: Risk identification involves identifying symptoms of risks. Risk Symptoms are the indictors or triggers for the actual risk event. For example, cost overrun may be symptomatic of poor estimation, or product defects may be symptomatic of a poor quality supplier. Identification and documentation of potential risk symptoms provides a diagnostic tool for project teams and suggests potential corrective action. The most effective way of identifying project risks is by using some form of systematic approach, whether it be by project management knowledge area, systems development life cycle phase or developing a customized checklist based on previous project experience. Risk events are specific things that may occur to the detriment of the project (e.g., significant changes in project scope, strikes, supply shortages, etc.). To characterize or define a risk event you need to examine and document the following parameters: 1. What is the probability of occurrence? 2. What is the impact to the project or the outcome if it does occur (severity)? 3. When it might occur? 4. How often it might occur (frequency)? Risk qualitative and quantification assessments: Risk analysis (qualitative or quantitative) is the process of evaluating risk to assess the range of possible project outcomes. The approach involves estimating probability of occurrence, potential impact on the project and possible mitigation strategies. By quantifying risks, project managers and terms can then rank and priorities them and establish acceptable risk thresholds. Expert judgment Many firms use the past experience and intuition of experts in lieu of or as a supplement to quantitative risk analysis. One common approach to gathering expert opinion is the Delphi method. The Delphi method is an approach used to derive a consensus among a panel of experts to make predictions about future developments. The method uses repeated rounds of questioning including feedback of earlier responses to take advantage of group input to refine the response. The process is continued until the group responses converge to a specific solution. This method works well in developing probability assessments for risk events. Expected monetary value: Expected monetary value is defined as the product of the risk event probability times the risk event s monetary value. That is, if the estimated cost of a risk event (e.g., the senior subject matter expert quitting and having to recruit and hire a new one) is $10,000 and the probability of it occurring is 20%, the expected monetary value would be 20% X $10,000=$2,000. Lecturer in Finance, DBA, IIUC, Website: 4

5 PERT estimations: Program evaluation and review technology (PERT) analysis, discussed in Block 2, is actually a highly simplified risk analysis method. It involves the provision of there estimates of an activity s duration- pessimistic, optimistic and most likely. The technique places four times the weight on the most likely estimate than on the optimistic or pessimistic ones. A more accurate and flexible method is something called Monte Carlo simulation. Monte Carlo Simulation for project risk analysis: Simulation uses a system model to analyze expected behavior or performance. Monte Carlo analysis is a risk quantification technique that simulates a model s outcome many times ( times) to provide a statistical distribution of the calculated results) It ties together sensitivity analysis and scenario analysis at a time. This is also a risk analysis technique which uses a computer to simulate future events and thus to estimate profitability and riskiness of the project. In simulation analysis, a computer firstly takes at random different values of each input variables (such as selling price, sales volume, variable cost per unit etc.) Then the values are combined and NPVs are calculated for each combination and stored in the computer. The process perhaps repeats for 1000 times to generate 1000 NPVs. Then the mean and standard deviation is calculated for every set of NPVs. Mean is used as a measure of project s profitability and standard deviation or co-variance is used as a measure of project s risk. Monte Carlo analysis also uses pessimistic, optimistic, and most likely estimates and the probabilities of their occurrence. Simulations such as these are a more sophisticated method for creating estimates than PERT and can more accurately help determine the likelihood of meeting project schedule or cost targets. Many organizations globally use Monte Carlo simulation for risk analysis. PC software programs provide Monte Carlo simulation capability to project management software like MS project and to standard PC spreadsheet. Sensitivity analysis: Sensitivity analysis is a project risk analysis technique which indicates how much the net present value of a project will be changed in response to a given change in a input variable ( such as unit sales, variable cost per unit), other things remain same. Since the future is uncertain, one may like to know what will happen to the variability of the project when some variable like sales or investment deviates from its expect values. In other ward, one may want to do a if what analysis or sensitivity analysis. Sensitivity analysis begins with a base case situation in which a NPV is calculated using expected value for each input. Then, each of the input variables is changed by several percentage points above & below the expected value and a new NPV is a calculated using value of input variables. Finally, a set of NPV is plotted in a graph to show how sensitive the NPV is to change in input variables. The slope of the line in the graph shows how sensitive the NPV is to change in input variable. Steeper the slope indicates risk or more sensitivity of the NPV to the given input variable and vice versa. Scenario analysis: In sensitivity analysis, only one variable is varies at a time. If the variable are interrelated, as they are most likely to be, it will be helpful to look at some reasonable scenarios, each scenario representing a consisting combination of variables. Scenarios in a project may be: Best scenario: High demand, high selling price, low variable cost and so on. Normal scenario: Average demand, average selling price, average variable cost and so on. Worst case scenario: low demand, low selling price, high variable cost and so on. Lecturer in Finance, DBA, IIUC, Website: 5

6 In scenario analysis the best and worst NPV is compared with normal NPV. Analysis begins with a normal or base case condition, then, financial analyst asks for information from the respective departments about the worst case and best case scenarios. Finally, NPVs are calculated for every scenario. If the project is successful, the combination of high demand, high selling price, low variable cost, results high NPV and vice versa. Break-even analysis: In sensitivity analysis we ask what will happen to the project if basic input variable changes (if sales increases, cost decline or some thing else happens). As a project manager, one should know how much should be produced or sold at a minimum to ensure that the project does not lose money. Such an analysis is called Break-even analysis. And the level of production at which loss can be avoided is called break-even production. Break-even analysis may be defined in accounting terms or financial terms. In accounting terms, the focus of Break-even analysis is on accounting profit. That is, it will identify at sales level or production level the net income will be zero. In financial terms, the focus of break-even analysis is on NPV. That is, it will identify at sales level or production level NPV will be zero. Using software in risk analysis Software tools are available to assist in various aspects of risk management. Risks can be tracked in databases or spreadsheets. Spreadsheet software can also assist in simple risk analysis. More sophisticated risk management software is also available that can help you build models and run simulations to analyze and respond to project risks. Monte Carlo simulation software is a particularly useful tool for helping to get a better idea of project risks and risk drivers. The sign of good risk management is that minimal crisis management is required (i.e., fires to put out) during the life of the project Risk response development: Risk response development is the process of taking steps to enhance opportunities and developing responses to risks. The following are the four basic responses to risk. Risk avoidance involves eliminating a risk or threat, usually by eliminating its causes (e.g., using hardware or software that is known to work, even though there may be newer solutions available) Risk acceptance can be either activate or passive: Passive acceptance means accepting the consequences should a risk occur. Active acceptance means developing a contingency plan should the risk occur-e.g. work around. Risk mitigation involves reducing the probability and /or the impact of a risk event. Risk transference involves transferring the risk to a third party e.g. buying insurance in the event that you have an accident Risk management plans, contingency plans and contingency reserves: A risk management plan documents the procedures for managing risk throughout the project. It summarizes the results of risk identification and analysis processes and describes what the project team s general approach to risk management will be. A risk management plan should address the following questions: o Why is it important to take / not take this risk in relation to the project objectives? o What is the specific risk and what are the risk mitigation deliverables? o What risk mitigation approach will be used? o Who are persons responsible for implementing the risk management plan? o When will the milestones associated with the mitigation approach occur? Lecturer in Finance, DBA, IIUC, Website: 6

7 o How much is required in terms of resources to mitigate risk? Contingency plans are predefined actions that the project team will take if an identified risk event occurs. Contingency reserves are provisions held in reserve by the project sponsor for possible changes in scope or quality that can be used to mitigate cost and or schedule risk Risk response control: Risk response control involves responding to risk events over the course of the project by executing the risk management plan and risk management processes. This requires on going risk awareness and monitoring. New risk may be identified during the course of the project and should go through the same assessment process as those identified in advance. When contingency plans are not in place or an unplanned risk event occurs, a workaround or temporary fix may need to be found Top ten-risk item tracking: Top ten-risk item tracking is a communication tool used for marinating awareness of risk throughout the life of a project. It consists of a periodic review with management and the customers of what they fell are the periods most significant risk items. A risk-tracking chart is developed that shows current and previous months to ten risks. Risk management reviews: Keep key stakeholders aware of factors that could prevent project success; Provide opportunities to develop and / r consider alternate risk mitigation strategies; & Promote confidence in the project team by demonstrating its ability to proactively manage risk. 8.5 Measurement of risk: Risk refers to the variability. It s a complex and multi-faceted phenomenon. A variety of measures have been uses to capture different facets of risk. The more important ones are: 1. Range 2. Standard deviation 3. Variance 4. Co-efficient of variation 5. Risk-adjusted rate of discount (RAD) method. 6. Sensitivity Analysis: Optimistic, most likely and pessimistic 7. Scenario Analysis: Tight, Aggressive, Average or worst, Best & Base situations 8. Decision-Three Analysis & Probability Analysis 9. Simulation Monte Carlo 10. Measuring Beta risk of a project or a port-folio & pure play method 8.6 Why risk and uncertainty is so indispensable in project management? 1. Risk and uncertainty is indispensable in capital budgeting exercise or project management as it involves long period of time and deals with future which is highly uncertain. 2. Risk differs due to nature of investments e.g. expansion project, R & D project, replacement project, etc. 3. It is highly unlikely that project planners can suggest accurate amount of cash inflows or useful life of the project. 4. Ever-increasing changes in technologies increase further risk and uncertainty 5. Change in market, taste & fashion of the people, income level, etc increase risk. Lecturer in Finance, DBA, IIUC, Website: 7

8 6. Change in economic conditions, interest and inflation rates as well as exchange rate further intensify the risk and uncertainty in project management. 7. Informal and unsystematic competition is a great challenge to project management e.g. smuggling, formation of trade blocs, etc. 8. Degree of Political risk. 9. Degree of Country risk. 10. Chance of nationalization and expropriation. 11. Risk of civil disobedience and war. 12. Uncongenial legal framework. 13. Unfriendly Political environment 14. Cost of prediction error in very high. 15. Irreversibility of project i.e. point of no return. 16. Irregular flows of foreign assistance, donors funds, international funds from international financing agencies like World Bank, Asian Development Bank, IMF, etc. 17. Shortage of skilled manpower for evaluation of project. 18. Fund utilization & supply position is very poor due to government failure to provide fund in time as per allocation, and to mobilize domestic resources. 19. Lack of co-ordination between government & donors. 20. Inefficiency of government ministries & machineries Problem # 1 Grameen Phone is considering a proposed project for its capital budget. The company estimates that the project s NPV is $12 million. This estimate assumes that the economy and market conditions will be average over the next few years. The company s CFO, however, forecasts that there is only a 50 percent chance that the economy will be normal. Recognizing this uncertainty, he also performed the following scenario analysis: Economic scenario Probability of outcome NPV Recession 0.05 ($70 million) Below average 0.20 (25 million) Average million Above average million Boom million What are the project s expected NPV, its standard deviation and its coefficient of variation. Problem # 2 Electricity generating project with equal annual cash flows assumed as follows SL No. Items Amount 1. Initial Cost Tk.10,00, Estimated life 10 years 3. Depriciation Tk.1,00,000/ per year 4. Operating cost Tk. 50,000/ per year 5. Power generated 1 Million K Wh/ per year 6. Market price of electricity Tk K Wh 7. Tax rate 40% 8. Discount rate 9% Lecturer in Finance, DBA, IIUC, Website: 8

9 Identify major sources of risk by making a sensitivity analysis with the change of 10% of all factors. Problem #3 ABC Company has the opportunity to invest in a plant for manufacturing a new product. The demand for which is estimated to be 5000 units a year for five years. The following data are related to the decision: 1 Machine cost Tk (no residual value) 2 Selling price per unit Tk Operating cost per Tk. 7 unit Overhead cost are not expected to be affected by the depreciation (ignored tax). The firm s cost of finance is 10%(assumed all cash flows are occurred at the end of year) Assess risk of the investment project with break even analysis. Problem #4 Berger Paint is going to introduce a new painting colour in the market. Before introducing the colour, the CFO wants to measure the risk of taking the project. Following information are available for the project: Particulars Amount Plant Cost Tk. 10,00,000 Estimated colour sold 1,00,000 liter per year Operating cost Tk. 2,00,000 Fixed cost Tk. 6,00,000 Price Tk. 50 per liter Depreciation Tk. 2,00,000 Tax rate 50% WACC 10% It is assumed that the project will have ten years life. You are requested to measure risk by using break-even analysis. Problem# 5 Bashundara Group is considering two mutually exclusive projects A and B. Project A costs Tk. 30,000 and project B costs Tk. 36,000. You are given the NPV and probability of each project hereunder: Project A Project B NPV (Tk.) Probability NPV (Tk.) Probability 3, , , , , , Lecturer in Finance, DBA, IIUC, Website: 9

10 15, , Requirement: a) Compute the expected NPV of both projects. b) Calculate risk associated with both projects. c) Which project should be considered? Problem# 6 KSRM is considering the risk characteristics of a project having initial investment of Tk. 48,000 and fixed cost of Tk. 2,500 per year for five years. Depreciation is Tk per year. The project is within 40% tax bracket and with 9% cost of capital. Project is expected to experience 1,500 units of quantity demanded with selling price of Tk. 45 per unit and variable cost Tk. 15 per unit. The manager of the finance department has estimated that there are two phases that might be faced by the project. If these phases occur there will be a change in some variables like selling price, depreciation, fixed cost and cost of capital. The changes have been stated in the following table: Variables Phases-A Phases-B Selling Price Tk. 50 Tk. 10 Depreciation 5,000 1,000 Fixed Cost 1,000 3,000 Cost of Capital 8% 10% Required: 1. Calculate the sensitivity analysis of NPV to the variation in underlying variables. 2. Calculate the accounting breakeven point and the financial breakeven point. Lecturer in Finance, DBA, IIUC, Website: 10