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Project risk management

By A.V. Vedpuriswar
Based on the work of Ashwath Damodaran

Introduction

Projects involve risk as cash flows are uncertain. How do we take the risks into account and decide whether the project is worth pursuing?

Adjusting for risk


The most common way of adjusting for risk is to compute a value that is risk adjusted. Risk adjustment can take the form of a higher discount rate or a reduction in expected cash flows. We can also do a post valuation adjustment to the value obtained for an asset. Risk adjustment can also be made by observing how the market discounts the value of assets of similar risk.

Discounted cash flow approach


The value of any asset is the present value of the expected cash flows on the asset.

Either we can use the same expected cash flows that a risk neutral investor would have used and adjust the risk free rate by adding a premium.
Or we can use the risk free rate as the discount rate and adjust the expected cash flows for risk, i.e., we replace uncertain cash flows by certainty equivalent cash flows. The more popular method is the risk adjusted discount rate approach; higher discount rates to discount expected cash flows when valuing riskier assets and lower discount rates when valuing safer assets.

Hybrid models
For some market wide risks such as exposure to internet rates, economic growth and inflation, it is often easier to estimate the parameters for a risk-and-return model and the risk adjusted discount rate. For other risks, it may be easier to adjust the expected cash flows.

Post valuation risk adjustment


Assess the risk by valuing the investment as if it has no risk. Adjust the value for risk after the valuation. The common practice is to capture some of the risks in the risk adjusted discount rate and deal with the other risks in the post valuation phase as discounts & premiums. Sometimes a post valuation discount may make sense, to reflect lack of liquidity.

Post valuation risk adjustment

Analysts valuing companies that are subject to regulation will sometimes discount the value for uncertainty about future regulatory changes.
A discount may also be applied in the case of companies that are vulnerable to lawsuit. Analysts may sometimes apply a control premium. A post valuation premium may be necessary if the expected cash flows do not fully capture the potential for large pay offs in some investments.

Scenario analysis

Various steps are involved in scenario analysis:


Determine the factors around which the scenarios will be built. Determine the number of scenarios to be analyzed for each factor. Estimate the asset cash flows under each scenario. Assign probabilities to each scenario.

Decision trees
This technique is useful when risk is not only discrete but also sequential. Decision trees help us to consider risk in stages and devise the right response to outcomes at each stage. The following steps are involved: Divide analysis into risk phases Estimate the probabilities of the outcomes in each phases

Define decision points


Compute cash flows/value at end nodes Fold back the tree

Simulation
Simulations provide a way of examining the consequences of continuous risk. Simulations allow for more flexibility in the way we deal with uncertainty. The steps in simulation are: Determine probabilistic variable. Define probability distributions for these variables. Check for correlation across variables.

Run the simulation.


When is simulation appropriate?

Real Options
The real options approach recognises that uncertainty can sometimes be a source of additional value, especially to those who are poised to take advantage of it. When investing in risky assets, we can learn from observing what happens in the real world. We can modify our behaviour by increasing our potential upside from the investment while reducing the possibilities downside.

But we do not take this into account while computing cash flows in traditional methods.

Real Options
The decision tree approach resembles real options in some ways. In both approaches, optimal decisions at each stage conditioned on outcomes at prior stages. But the decision tree approach isbuilt on probabilities and allows for multiple outcomes at each branch. In the real options approach there are typically only two outcomes at each stage and the probabilities are not specified. In the real options approach, the discount rate will vary depending on the branch of the tree being analysed.

Real Options

There are potentially three real options in many investment situations: The first is the option to delay.

The second is the option to expand.


The third is the option to abandon an investment, if it looks like a money loser, early in the process.

Real Options
The real options approach recognises maintaining flexibility in both operating decisions. the value of and financial

The value of real options is greatest when we have exclusivity.

The danger with the real options framework is that it is often used to justify bad investments and decisions.
Not all opportunities are options and not all options have significant economic value.