Project Risk: Amity Business School
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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)
Amity Business School
Why CapEx Project is Risky
• Unique – No Previous History • Huge Strategic Impact • Long Gestation Period • Large Number of Players
Amity Business School
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.
Amity Business School
Contd. • Site selection-investment decision-Finalizing technical package-implementation scheduleobtaining LOI-conducting contour survey and Benchmarking-Conducting investigation of ground water-development of plot planmanpower-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,
Amity Business School
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.
Amity Business School
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.
Amity Business School
Stages for Risk Identification • Pre-operative Stage Risks – Development Stage Risks – Construction Stage Risk • Operational Stage Risks • Political Risks
Amity Business School
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
Amity Business School
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
Amity Business School
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
Amity Business School
Financing/Refinancing Risk • Acceptance for Mandate Risk • Credit Rating Risk • Subscription Risk • Timely Availability Risk • Change in Financing Plan
Amity Business School
• 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.
Amity Business School
Development or Bid Risk • Project Feasibility Related • Country Feasibility Specific • Bid Related
Amity Business School
• 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
Amity Business School
• • • • • • • • • • • •
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.
Amity Business School
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
Amity Business School
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.
Amity Business School
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.
Amity Business School
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.
Amity Business School
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.
Amity Business School
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.
Amity Business School
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.
Amity Business School
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.
Amity Business School
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.
Amity Business School
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.
Amity Business School
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 project’s reserves functioning of upgradrer
•Only 7% of estimated reserve is required for project (120,000*365*35)/21.5 = 7.1%
Technological Risk
• The drilling technology and Conoco refining technology are proven
•External agency, Stone & Webster found design to be in accordance to good industry practices
Timing and Completion Risk
• 3 segments and complex • Timely finish to realize early project cash flows • Use of local players
•Stone & Webster found execution schedule to be achievable •Use of known technologies
Post-completion Risks Category
General Risk
Amity Business School Possibility of Occurrence
Market Risk
• Price of oil is volatile • Lack of established market for syncrude
•Chem Systems found the pricing to be reasonable and consistent with market 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 by government or PDVSA utilities are located in Venezuela •Post-completion, project would be independent Throughput Risk
• Simultaneous •Usage of known technologies and functioning of 3 experienced participants components to produce the syncrude •Engineers didn’t expect varying density • Varying density of to be a major problem crude effecting the efficiency
Amity Business School
Macroeconomic Risks Category
General Risk
Possibility of Occurrence
Exchange Rate Risks
• Appreciation of Bolivar will increase local operating costs and tax liability
•Between 1995 and 1996, Bolivar depreciated over 64%
Currency Convertibility and Transferability Risk
• No exchange rate control since 1996
•Petrozuata has approval for an offshore dollar denominated proceeds account •PDVSA has similar account and has never defaulted on payments
Inflation Risk
• High levels of inflation with nearly 100% in 1996
•No possible remedy except favorable exchange rate movements
Sovereign & Legal Risks
Amity Business School
Category
General Risk
Possibility of Occurrence
Expropriation Risks
• Nationalization of oil industry in 1976 • Forceful selling of output to others than Conoco • Diversion of payments against the revenue waterfall agreement • Preferential tax and royalty rate treatment
•Petrozueta is the first in a series of planned projects to any failure of government might hamper those projects •In case of diversions, it may be difficult to get new buyers as most of these are located on US Gulf Coast 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 Risk
• Sovereign right to all oil assets resulting in no claim on debt holders in case of default
•No possible remedy
Amity Business School
Mitigation Strategies • Insure • Allocate • Hedge • Deter • Bear
Risk Classification Type of Risk
Amity Business School
Macroeconomic Risk (Exchange Rate Risk, Interest Rate Risk, Inflation) Market Demand Risk
Project
Force Majeure (Acts of God) Counterparty Risk
Financing Risk Sovereign & Legal Risk Macroeconomic Risk (Currency Convertibility and Transferability) Construction Stage Risk (Delays in getting permits/ land acquisition, Cost/Time Overruns) Operational Stage Risk (Demand and Supply Risk, Management Risk, Environmental Risk)
Low
High
Ability to Control
Agreements to Mitigate Risk
Amity Business School
• Financing Agreements • Construction Agreements • Sales or Off-take Agreements • Supplies Agreements
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)
Amity Business School
Why CapEx Project is Risky
• Unique – No Previous History • Huge Strategic Impact • Long Gestation Period • Large Number of Players
Amity Business School
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.
Amity Business School
Contd. • Site selection-investment decision-Finalizing technical package-implementation scheduleobtaining LOI-conducting contour survey and Benchmarking-Conducting investigation of ground water-development of plot planmanpower-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,
Amity Business School
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.
Amity Business School
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.
Amity Business School
Stages for Risk Identification • Pre-operative Stage Risks – Development Stage Risks – Construction Stage Risk • Operational Stage Risks • Political Risks
Amity Business School
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
Amity Business School
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
Amity Business School
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
Amity Business School
Financing/Refinancing Risk • Acceptance for Mandate Risk • Credit Rating Risk • Subscription Risk • Timely Availability Risk • Change in Financing Plan
Amity Business School
• 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.
Amity Business School
Development or Bid Risk • Project Feasibility Related • Country Feasibility Specific • Bid Related
Amity Business School
• 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
Amity Business School
• • • • • • • • • • • •
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.
Amity Business School
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
Amity Business School
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.
Amity Business School
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.
Amity Business School
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.
Amity Business School
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.
Amity Business School
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.
Amity Business School
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.
Amity Business School
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.
Amity Business School
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.
Amity Business School
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.
Amity Business School
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 project’s reserves functioning of upgradrer
•Only 7% of estimated reserve is required for project (120,000*365*35)/21.5 = 7.1%
Technological Risk
• The drilling technology and Conoco refining technology are proven
•External agency, Stone & Webster found design to be in accordance to good industry practices
Timing and Completion Risk
• 3 segments and complex • Timely finish to realize early project cash flows • Use of local players
•Stone & Webster found execution schedule to be achievable •Use of known technologies
Post-completion Risks Category
General Risk
Amity Business School Possibility of Occurrence
Market Risk
• Price of oil is volatile • Lack of established market for syncrude
•Chem Systems found the pricing to be reasonable and consistent with market 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 by government or PDVSA utilities are located in Venezuela •Post-completion, project would be independent Throughput Risk
• Simultaneous •Usage of known technologies and functioning of 3 experienced participants components to produce the syncrude •Engineers didn’t expect varying density • Varying density of to be a major problem crude effecting the efficiency
Amity Business School
Macroeconomic Risks Category
General Risk
Possibility of Occurrence
Exchange Rate Risks
• Appreciation of Bolivar will increase local operating costs and tax liability
•Between 1995 and 1996, Bolivar depreciated over 64%
Currency Convertibility and Transferability Risk
• No exchange rate control since 1996
•Petrozuata has approval for an offshore dollar denominated proceeds account •PDVSA has similar account and has never defaulted on payments
Inflation Risk
• High levels of inflation with nearly 100% in 1996
•No possible remedy except favorable exchange rate movements
Sovereign & Legal Risks
Amity Business School
Category
General Risk
Possibility of Occurrence
Expropriation Risks
• Nationalization of oil industry in 1976 • Forceful selling of output to others than Conoco • Diversion of payments against the revenue waterfall agreement • Preferential tax and royalty rate treatment
•Petrozueta is the first in a series of planned projects to any failure of government might hamper those projects •In case of diversions, it may be difficult to get new buyers as most of these are located on US Gulf Coast 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 Risk
• Sovereign right to all oil assets resulting in no claim on debt holders in case of default
•No possible remedy
Amity Business School
Mitigation Strategies • Insure • Allocate • Hedge • Deter • Bear
Risk Classification Type of Risk
Amity Business School
Macroeconomic Risk (Exchange Rate Risk, Interest Rate Risk, Inflation) Market Demand Risk
Project
Force Majeure (Acts of God) Counterparty Risk
Financing Risk Sovereign & Legal Risk Macroeconomic Risk (Currency Convertibility and Transferability) Construction Stage Risk (Delays in getting permits/ land acquisition, Cost/Time Overruns) Operational Stage Risk (Demand and Supply Risk, Management Risk, Environmental Risk)
Low
High
Ability to Control
Agreements to Mitigate Risk
Amity Business School
• Financing Agreements • Construction Agreements • Sales or Off-take Agreements • Supplies Agreements
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