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