Introduction

➢ First we consider the determination an appropriate risk discount

rate or hurdle rate which should reflect both the opportunity
cost of capital and the degree of systematic risk inherent in a
project.
➢ Then we will introduce a general approach for analysing and
dealing with the risks that will be present in any project
➢ We look in detail at the identification of risk, the analysis of risk,
the distribution of net present values, other ways of appraising
risky projects, risk mitigation and finally, the investment
submission.

Ch-7 Project Assessment 2 Page 1

Choice of discount rate

The basic theory

Background
➢ The use of the cost of capital to calculate the net present value
in screening projects ensures that only projects that will enhance
the return to shareholders are taken on, provided that the cost
of capital is adjusted to reflect the project risk.
➢ The historical costs of the company’s existing capital is
irrelevant. What is important is the current cost of raising
incremental capital for the company to carry out the project.
➢ This cost is the rate of return which needs to be earned on the
capital if the existing shareholders are to be no better or no
worse off.
➢ If all the capital were to be raised from internal reserves or by a
rights issue, the cost of capital would be equal to the total rate of
return which could be expected to be earned by the
shareholders on their existing shares.
➢ If, however, the whole of the capital were to be raised from
fixed-interest borrowing, it would be the net cost of that
borrowing after allowing for tax reliefs and likely future inflation,
which would need to be taken as the cost of capital.
➢ If part of the capital were raised through equity and part through
borrowing, we would need to look at the weighted average cost.

Weighted average cost of capital

➢ The WACC is a weighted average of the cost of debt and equity

capital of the company.
➢ If the company is able to generate a rate of return in excess of its
WACC from a particular project, then that project:
i. has a positive NPV calculated at the WACC and offers a return to
the shareholders in excess of the WACC
ii. will increase the value of the company, where this is calculated

Ch-7 Project Assessment 2 Page 2

ii. will increase the value of the company, where this is calculated
as the NPV of all of its future cashflows, and therefore make the
shareholders better off.

➢ The WACC varies with the level of gearing and hence the optimal
capital structure will be that which minimises the WACC and
maximises the value of the company.
➢ The cost of debt capital should be taken as the cost in real terms
of new borrowing by the company. This is calculated by taking an
appropriate margin over the current expected total real return
on index-linked bonds, having regard to the company’s credit
rating, and multiplying by (1 – t), where t is the assumed rate of
corporation tax.
➢ The cost of equity capital should be taken as the current
expected total real return on index-linked bonds plus a suitable
margin to allow for the additional return which equity investors
seek to compensate them for the risks they run.

Ch-7 Project Assessment 2 Page 3

Systematic Risk & CAPM

Allowing for systematic risk

➢ Beta is a measure of the systematic risk inherent in the asset.

➢ ‘Systematic risk’ is that part of the return on a project that
cannot be eliminated by investing in the same type of project
many times over, nor by diversification, because investing in a
number of projects cannot reduce this part of the variability to
zero.
➢ Systematic risk should be allowed for by varying the discount
rates used in the model.
➢ For example, an international company might apply a higher
discount rate to projects located in countries with unstable
political regimes.

Look at other companies

➢ One guide might be to consider the discount rates which would
be appropriate for use by any companies which habitually
engage in such projects, using the above methodology.
➢ But the companies that habitually engage in such projects may
have more experience of such projects and so be better able to
mitigate the inherent risks involved. If this is the case, then a
slightly higher discount rate than that used by other companies
might actually be appropriate.

CAPM-based approach
➢ The CAPM model can be used to estimate the returns required
from a capital project.
➢ This required rate of return can then be used as a risk discount
rate to price the project.
➢ The project beta measures the systematic risk of the project and
so the above equation gives a higher/lower risk discount rate for
projects with a higher/lower level of systematic risk.
Ch-7 Project Assessment 2 Page 4
 projects with a higher/lower level of systematic risk.

Factors influencing beta in practice

We would adjust our historic value of beta when we feel that
investors would see the project as being more (or less) risky than the
typical company venture. Issues to consider include:
i. cyclicality – does the outcome of the project depend strongly on
the state of the economy and the business cycle?
ii. operating leverage – does the project involve a high proportion
of fixed (as opposed to variable) costs?. If a project has high fixed
costs, this adds to the risk as there is a greater chance the
project will give a negative return when revenues fall.
Positive answers to either of these questions will suggest a higher
value should be used for beta.

Practical experience
➢ Many companies apply the same cost of capital to all projects.
This can lead to wrong decisions being made if the systematic
risk of different projects is substantially different.
➢ It has been found that use of different costs of capital can lead to
internal friction within a company which can, along with the
complexity of the method, mean that the theoretically correct
approach is often ignored.
➢ It is not uncommon for companies to use very high discount or
hurdle rates when appraising proposed projects.
➢ Use of a very high discount rate could lead to the danger of the
incorrect acceptance of a risky project with a high apparent NPV
or the incorrect rejection of a low-risk project with a negative
NPV, which would have a positive NPV if this were calculated on
a lower but more appropriate discount rate.
➢ In any case it would usually be appropriate to carry out the NPV
calculations on two alternative discount rates, and if both results
are satisfactory, then there is no need to worry too much about
Ch-7 Project Assessment 2 Page 5
are satisfactory, then there is no need to worry too much about
determining the most appropriate discount rate precisely

Ch-7 Project Assessment 2 Page 6

Ch-7 Project Assessment 2 Page 7
Certainty Equivalents

➢ The use of a risk discount rate for establishing the present value
of future project cashflows combines the two elements of time
value of money and the level of risk associated with the
cashflow.
➢ As the level of risk may vary according to the nature of the item
being assessed, we should strictly use a different risk discount
rate for each element.
➢ To avoid this, we replace the individual (risky) projected
cashflows with their certainty equivalents.
➢ In this way we produce a series of ‘certain’ cashflows that can
then be discounted at a uniform rate of return.

Ch-7 Project Assessment 2 Page 8

Risk Analysis

➢ When we use the word ‘risk’, we mean either an event which

leads to a variation from the most likely outcome in either
direction or the probability of occurrence of such an event.

➢ With any project there are risks and these can be divided into
two types:
1. Systematic: ‘in the system’ and which affect the whole area of
the business into which the project falls, eg price of land for a
building project.
2. Specific: ‘specific to the project’ and which can be diversified
away by the company, eg the risk of a cold summer reducing ice-
cream sales diversified by also selling hot dogs

➢ Risks specific to the project should be determined by a risk

analysis of the project.
➢ It may sometimes be difficult to determine into which of these
two categories a risk should fall, but the temptation to classify
too many risks as systematic to reduce the analytical work
should be resisted.

➢ To deal with the risks of a given activity, we need to:

i. identify them
ii. analyse them, by estimating the frequency of occurrence and the
consequences if they occur
iii. consider the possibility of mitigating the downside risks, by
reducing the frequency of occurrence or reducing the adverse
consequences, or both
iv. consider the costs of possible mitigation options, to see whether
they are financially viable or not and select the best combination
of mitigation options.
v. The remaining or residual risks are the ones which must be
accepted by the sponsors and/or investors.

➢ If the project is undertaken, the residual risks need to be

controlled using a series of measures which include:
i. regular monitoring of the risks
Ch-7 Project Assessment 2 Page 9
 i. regular monitoring of the risks
ii. plans for dealing with foreseeable and unforeseeable crises
iii. appointment of risk custodians
iv. regular management reviews.

Ch-7 Project Assessment 2 Page 10

Identification of Risks

➢ A methodology for Risk Assessment and Management of Projects

(RAMP) has been developed jointly between the Faculty and
Institute of Actuaries and Institute of Civil Engineers.
➢ The steps necessary to achieve an effective identification of the
risks (upside as well as downside) facing the project can be
summarised as follows:
i. Make a high-level preliminary risk analysis to confirm that the
project does not have such a high risk profile that it is not worth
analysing further.
ii. Hold a brainstorming session of project experts and senior
internal and external people who are used to thinking
strategically about the long term. The aim will be to identify
project risks, both likely and unlikely, to discuss these risks and
their interdependency, to attempt to place a broad initial
evaluation on each risk, both for frequency of occurrence and
probable consequences if it does occur, and to generate initial
mitigation options and discuss them briefly.
iii. Carry out a desktop analysis to supplement the results from the
brainstorming session, by identifying further risks and mitigation
options, using a general risk matrix, researching similar projects
undertaken by the sponsor or others in the past, and obtaining
the considered opinions of experts who are familiar with the
details of the project and the outline plans for financing it.
iv. Carefully set out all the identified risks in a risk register, with
cross references to other risks where there is interdependency.

Risk matrices
➢ These are helpful in the identification and analysis of risks.
➢ The basic idea is to construct a table or tables with different
generic categories and sub-categories of risk as the column and
row headings.
➢ One method by which to categorise risks is according to:
i. the cause of the risk (eg as columns)
ii. the stage of the project at which the risk arises (eg as rows).

➢ Subheadings could then be used to subdivide the risks into more

tightly defined subcategories, eg splitting the natural causes of
Ch-7 Project Assessment 2 Page 11
 tightly defined subcategories, eg splitting the natural causes of
risk into various types such as weather, earthquake etc
➢ The identified risks, their characteristics and importance can
then documented in the matrix.
➢ The categorisation of risks into different types may also aid with
the identification of interdependencies

Causes of Risk
i. political
ii. business
iii. economic
iv. project
v. natural
vi. financial
vii. crime.

Stages of the project

i. promotion of concept
ii. design
iii. contract negotiations
iv. project approval
v. raising of capital
Ch-7 Project Assessment 2 Page 12
 v. raising of capital
vi. construction
vii. operation and maintenance
viii. receiving revenues
ix. decommissioning.

➢ Some of the risks identified will probably be such that no realistic

estimates can be made of probability of occurrence or likely
consequences, and it may be that some such risks can be
regarded as being systematic rather than probabilistic and hence
already accounted for in the discount rate.
➢ It should be emphasised that risks of very serious or disastrous
events, however uncertain or however low the probability of
Ch-7 Project Assessment 2 Page 13
events, however uncertain or however low the probability of
occurrence, should never be ignored on the grounds that an
allowance has been made for them in the discount rate. Such
risks should always be the subject of searching analysis.

Ch-7 Project Assessment 2 Page 14

Ch-7 Project Assessment 2 Page 15
Analysis of risks

➢ Having identified the risks inherent in the project, the next step
is to attempt to quantify their impact upon the financial returns
yielded by the project.
➢ Once the identification process is regarded as complete, an
analysis of the risks is done to ascertain the frequency of
occurrence and the consequences if the risk event occurs.
➢ The analysis will concentrate on the independent risks and
regard the dependent risks as consequences of them.
➢ The risks could be classified according to four different
dimensions:
i. Frequency of occurrence – the perceived likelihood that the
particular risk will occur. The categories used might vary from
‘very likely’ to ‘very unlikely
ii. Impact – the effect on the cashflows. The occurrence of a risk
with a major negative impact upon the project could lead to its
cancellation.
iii. Degree of dependence – of the various risks. Categories here
could range from ‘very high degree’ to ‘very low degree’.
iv. Controllability – the extent to which the impact of the risk can
be mitigated or managed. Here the categories could range from
‘can be completely mitigated’ to ‘very uncontrollable’. The cost
of control might also be considered here.

➢ The risk(s) in each cell of the risk matrix are therefore essentially
awarded a score for each of the above dimensions and the most
important risks in terms of their likely financial impact are
thereby identified.
➢ The most crucial aspect of risk is probably the absolute
magnitude of the financial impact.

Financial consequences of risks

➢ The financial consequences if the event occurs will be expressed
in present day money values (after removing the effects of
inflation).

Ch-7 Project Assessment 2 Page 16

➢ The expected NPV of the risk in question will be derived by
summing a series of expected NPVs in respect of all future years
covered by the analysis. The expected NPV for a potential future
year will be the probability of occurrence of the event in that
year (derived from the estimated frequency of occurrence)
multiplied by the NPV of the resulting incremental or
decremental cashflows if the event occurs in that year.
➢ The risks will then be prioritised for further analysis. In general
the risks with low expected NPVs will be discarded, with the
intention of including them in a general contingency allowance
later.
➢ However, any risks which would have very serious or disastrous
consequences, but where the expected NPV is low because the
probability of occurrence is small, would be kept for further
analysis along with the risks having higher expected NPVs.

Ch-7 Project Assessment 2 Page 17

Ch-7 Project Assessment 2 Page 18
Ch-7 Project Assessment 2 Page 19
Ch-7 Project Assessment 2 Page 20
Obtaining a distribution of NPVs in practice

1. Scenario Analysis
➢ The first is to construct a series of future scenarios, each
representing a combination of possible outcomes for the major
risk events and each having its own probability of occurrence,
obtained by combining the probabilities of the various
independent component risks.
➢ The outcomes selected for the scenario analysis will in practice
often be the mid-points of a range of possible values. For
example, if there is an 80% chance that the capital cost will lie
between £40m and £42m, and a 20% chance that it will lie
between £42m and £50m, one might model two sub-scenarios,
the first having a capital cost of £41m with an 80% probability
and the other having a capital cost of £46m with a 20%
probability. If each of these 2 sub-scenarios for capital cost were
to be combined with (say) 4 sub-scenarios on gross revenue and
3 sub-scenarios on running costs, we would generate a total of 2
* 4 * 3 = 24 scenarios.
➢ For each scenario the probability of occurrence and the NPV if it
occurs are calculated.
➢ Assuming that the scenarios cover all possible outcomes, at least
in principle, the result will be an approximate probability
distribution of the NPVs of the project.

Ch-7 Project Assessment 2 Page 21

2. Stochastic Modelling
➢ The other main method is to build a computer-based stochastic
model, in which the various risks are modelled and a series of
simulations is then run to get a probability distribution of the
NPVs. We also get the distributions of the various input
variables.
➢ This approach may give a better overall feel for the variability of
the possible financial outcomes.

Relative merits of the two approaches

➢ It may appear that the second method would be superior,

Ch-7 Project Assessment 2 Page 22
➢ It may appear that the second method would be superior,
practical experience has shown that the results from a stochastic
model cannot always be relied upon with sufficient confidence
to justify the effort and expense involved (increased workload &
costly).
➢ When building a stochastic model, the most difficult data to
estimate reliably are the correlation coefficients linking the
various input parameters.
➢ There is the danger of losing sight of key factors and
assumptions in looking at the output from such a model.
➢ The effort of working up a scenario analysis by hand often forces
the analyst to concentrate on the important risks and
assumptions.
➢ Despite this, however, a comparatively simple stochastic model
may be useful to simulate one specific project activity, where the
assumptions underlying the model, and its limitations, can be
kept clearly in view.

Unfavourable NPVs

➢ Having arrived at a probability distribution of NPVs for the

project, it will often be found that some of the resulting NPVs
are ‘unfavourable’, i.e. they are unacceptably low or negative.
➢ Some of these unfavourable NPVs may have low probabilities of
occurrence attached to them, and the sponsor may be prepared
to accept these risks.
➢ However the NPV may be so unfavourable that even with a low
probability of occurrence it is unacceptable.
➢ For example, the financial consequences of a natural disaster on
a construction project may be enormous, perhaps even
threatening the solvency of the company.
➢ The consequent and unacceptably high downside risk might then
mean that the project is not considered viable, even though the
project has a positive expected NPV & probability of the risk
occurring is very small.

Ch-7 Project Assessment 2 Page 23

Risk Mitigation

Risk mitigation is aimed at reducing either the probability that a risk

occurs and/or the financial impact should it occur.

Ways of mitigating risk

➢ For each major risk, consideration would be given to identifying

the main options for mitigating the risk, by such methods as:
i. avoiding the risk (eg by redesigning the project)
ii. reducing the risk, i.e. either reducing the probability of
occurrence or the consequences or both (eg by modifying the
design or building in safety margins or procedures)
iii. reducing uncertainty (eg through further research or a feasibility
study)
iv. transferring risk (eg through engaging a sub-contractor on a fixed
price contract)
v. insuring risk (in fact a particular case of risk transfer)
vi. sharing risk with another party (especially where the other party
is able to control the risk to some extent).

➢ Each option for mitigating a particular risk will be evaluated,

assessing:
i. likely effect on frequency, consequence and expected value
ii. feasibility and cost of implementing the option. The cost of
implementing the option will normally reduce the expected NPV
of the project.
iii. any ‘secondary risks’ resulting from the option. A strategy that
reduces one element of risk, could introduce an additional, but
less important risk, eg insurance introduces the small risk that
the insurer could default.
iv. further mitigating actions to respond to secondary risks. For
example, insurance could be arranged with a number of insurers
instead of just one to reduce the exposure to any one insurer
defaulting.
v. overall impact of each option on the distribution of NPVs.

The financial consequences of risk mitigation

➢ The result of adopting a particular option ought to be to reduce
Ch-7 Project Assessment 2 Page 24
➢ The result of adopting a particular option ought to be to reduce
the downward volatility of the NPVs but in addition it will
normally either:
i. increase the expected NPV
ii. decrease the expected NPV.

➢ In the former case, the mitigation option is entirely beneficial

and should be built in to the project. This is because risk has
been reduced and expected return increased.
➢ In the second, and more normal, case, judgement will have to be
exercised on whether the mitigation option in question should
be adopted. In this more usual case, risk has been reduced at the
expense of a reduction in expected return.

Ch-7 Project Assessment 2 Page 25

The Investment Submission

➢ A decision will now need to be taken on whether the project

should proceed & whether it meets the sponsor's criteria.
➢ The investment submission, which is to be used as a basis for this
decision, should assume that the best possible combination of
mitigation options will be implemented.
➢ It should show the expected NPV (allowing for both upside and
downside risk) and the probability distribution of NPVs.
➢ The residual risks should be fully identified and analysed.
➢ Particular attention needs to be paid in the submission to any
remaining risks that could have a serious or catastrophic effect
on the outcome of the project as a whole, even if they have a
low or uncertain probability of occurrence.
➢ The method by which it is proposed to finance the project should
be specified, and an analysis provided showing the likely effect
on investors after taking account of expected price inflation,
borrowing, tax, etc.
➢ The decision makers will need to pay attention not only to the
submission but to a range of considerations that are outside the
scope of the formal analysis. Such considerations might include:
• allowance for any likely bias or possible approximations in the
estimates
• Hunch: This means any gut feelings or instincts, perhaps based
on previous experience.
• knowledge not in the possession of those who have prepared
the submission
• last-minute developments
• doubts about feasibility or quality of implementation
• overall project credibility

➢ Finally, judgement will be required on whether, taking all these

aspects into account, the project meets the sponsor’s criteria
sufficiently to justify a decision to proceed.

➢ If the decision is to taken to proceed with the project, then it is

important that all aspects of the project are reviewed regularly
to assess its ongoing profitability.
Ch-7 Project Assessment 2 Page 26
 to assess its ongoing profitability.
➢ Should the project be rejected, it is important to bear in mind
that circumstances may change, eg an economic upturn may
enhance the projected profitability of the project to the extent
that it is deemed viable at a future date.
➢ Thus, in each time period we could think of the decision to be
made as a choice between starting the project now or deferring
the start of the project until at least the next time period when
the circumstances are favourable for the project.

Ch-7 Project Assessment 2 Page 27

Core Reading Examples

Example 1

Ch-7 Project Assessment 2 Page 28

Ch-7 Project Assessment 2 Page 29
Ch-7 Project Assessment 2 Page 30