UNIT-3

SYLLABUS
Project appraisal - methods; economic analysis, financial analysis, technical feasibility,
management competence, project appraisal techniques; payback period, accounting rate of
return, net present value, internal rate of return, benefit cost ratio; social cost benefit analysis,
risk analysis; measures of risk, sensitivity analysis, stimulation analysis, decision tree analysis.

NOTES

PROJECT APPRAISAL
Project appraisal is a cost and benefits analysis of different aspects of proposed project with an
objective to adjudge its viability. A project involves employment of scarce resources. An entrepreneur
needs to appraise various alternative projects before allocating the scarce resources for the best project.

Project Appraisal is a consistent process of reviewing a given project and evaluating its content to
approve or reject this project, through analyzing the problem or need to be addressed by the project,
generating solution options (alternatives) for solving the problem, selecting the most feasible option,
conducting a feasibility analysis of that option, creating the solution statement, and identifying all people
and organizations concerned with or affected by the project and its expected outcomes. It is an attempt to
justify the project through analysis, which is a way to determine project feasibility and cost-effectiveness.

PROJECT APPRAISAL - METHODS

1. Economic Analysis:
Under economic analysis, the project aspects highlighted include requirements for raw material, level of
capacity utilization, anticipated sales, anticipated expenses and the probable profits. It is said that a
business should have always a volume of profit clearly in view which will govern other economic
variables like sales, purchases, expenses and alike.

It will have to be calculated how much sales would be necessary to earn the targeted profit. Undoubtedly,
demand for the product will be estimated for anticipating sales volume. Therefore, demand for the
product needs to be carefully spelled out as it is, to a great extent, deciding factor of feasibility of the
project concern.

2. Financial Analysis:
Finance is one of the most important pre-requisites to establish an enterprise. It is finance only that
facilitates an entrepreneur to bring together the labour of one, machine of another and raw material of yet
another to combine them to produce goods.
In order to adjudge the financial viability of the project, the following aspects need to be carefully
analysed:

1. Assessment of the financial requirements both – fixed capital and working capital need to be
properly made. You might be knowing that fixed capital normally called ‘fixed assets’ are those tangible
and material facilities which purchased once are used again and again. Land and buildings, plants and
machinery, and equipment’s are the familiar examples of fixed assets/fixed capital. The requirement for
fixed assets/capital will vary from enterprise to enterprise depending upon the type of operation, scale of
operation and time when the investment is made. But, while assessing the fixed capital requirements, all
items relating to the asset like the cost of the asset, architect and engineer’s fees, electrification and
installation charges (which normally come to 10 per cent of the value of machinery), depreciation, pre-
operation expenses of trial runs, etc., should be duly taken into consideration. Similarly, if any expense is
to be incurred in remodeling, repair and additions of buildings should also be highlighted in the project
report.

2. In accounting, working capital means excess of current assets over current liabilities. Generally, 2: 1
is considered as the optimum current ratio. Current assets refer to those assets which can be converted
into cash within a period of one week. Current liabilities refer to those obligations which can be payable
within a period of one week. In short, working capital is that amount of funds which is needed in day
today’s business operations. In other words, it is like circulating money changing from cash to inventories
and from inventories to receivables and again converted into cash.

3. Market Analysis:

Before the production actually starts, the entrepreneur needs to anticipate the possible market for the
product. He/she has to anticipate who will be the possible customers for his product and where and when
his product will be sold. There is a trite saying in this regard: “The manufacturer of an iron nails must
know who will buy his iron nails.”

The commonly used methods to estimate the demand for a product are as follows:
1. Opinion Polling Method:
In this method, the opinions of the ultimate users, i.e. customers of the product are estimated. This may be
attempted with the help of either a complete survey of all customers (called, complete enumeration) or by
selecting a few consuming units out of the relevant population (called, sample survey).

Let us discuss these in some details:

(a) Complete Enumeration Survey:
In this survey, all the probable customers of the product are approached and their probable demands for
the product are estimated and then summed. Estimating sales under this method is very simple. It is
obtained by simply adding the probable demands of all customers. An example should make it clear.

Suppose, there are total N customers of X product and everybody will demand for D numbers of it. Then,
the total anticipated demand will be:
N ∑ i=1 DiN
Though the principle merit of this method is that it obtains the first-hand and unbiased information, yet it
is beset with some disadvantages also. For example, to approach a large number of customers scattered all
over market becomes tedious, costly and cumbersome. Added to this, the consumers themselves may not
divulge their purchase plans due to the reasons like their personal as well commercial/business privacies.

(b) Sample Survey:

Under this method, only some number of consumers out of their total population is approached and data
on their probable demands for the product during the forecast period are collected and summed. The total
demand of sample customers is finally blown up to generate the total demand for the product.

(c) Sales Experience Method:

Under this method, a sample market is surveyed before the new product is offered for sale. The results of
the market surveyed are then projected to the universe in order to anticipate the total demand for the
product.

(d) Vicarious Method:

Under the vicarious method, the consumers of the product are not approached directly but indirectly
through some dealers who have a feel of their customers. The dealers’ opinions about the customers’
opinion are elicited. Being based on dealers’ opinions, the method is bound to suffer from the bias on the
part of the dealers. Then, the results derived are likely to be unrealistic. However, these hang-ups are not
avoidable also.

2. Life Cycle Segmentation Analysis:

It is well established that like a man, every product has its own life span. In practice, a product sells
slowly in the beginning. Backed by sales promotion strategies over period, its sales pick up. In the due
course of time, the peak sale is reached. After that point, the sales begin to decline. After, some time, the
product loses its demand and dies. This is natural death of a product. Thus, every product passes through
its ‘life cycle’. This is precisely the reason why firms go for new products one after another to keep
themselves alive.

Based on above, the product life cycle has been divided into the following five stages:
1Introduction
2. Growth
3. Maturity
4. Saturation
5. Decline
The sales of the product vary from stage to stage and follows S-shaped curve:-
Considering the above five stages of a product life cycle, the sales at different stages can be anticipated.

4. Technical Feasibility:
While making project appraisal, the technical feasibility of the project also needs to be taken into
consideration. In the simplest sense, technical feasibility implies to mean the adequacy of the proposed
plant and equipment to produce the product within the prescribed norms. As regards know-how, it
denotes the availability or otherwise of a fund of knowledge to run the proposed plants and machinery.

It should be ensured whether that know-how is available with the entrepreneur or is to be procured from
elsewhere. In the latter case, arrangement made to procure it should be clearly checked up. If project
requires any collaboration, then, the terms and conditions of the collaboration should also be spelt out
comprehensively and carefully.

In case of foreign technical collaboration, one needs to be aware of the legal provisions in force from time
to time specifying the list of products for which only such collaboration is allowed under specific terms
and conditions. The entrepreneur, therefore, contemplating for foreign collaboration should check these
legal provisions with reference to their projects.

While assessing the technical feasibility of the project, the following inputs covered in the project
should also be taken into consideration:
(i) Availability of land and site.
(ii) Availability of other inputs like water, power, transport, communication facilities.
(iii) Availability of servicing facilities like machine shops, electric repair shop, etc.
(iv) Coping-with anti-pollution law.
(v) Availability of work force as per required skill and arrangements proposed for training-in-plant and
outside.
(vi) Availability of required raw material as per quantity and quality.

5. Management Competence:
Management ability or competence plays an important role in making an enterprise a success or
otherwise. Strictly speaking, in the absence of managerial competence, the projects which are otherwise
feasible may fail.

On the contrary, even a poor project may become a successful one with good managerial ability. Hence,
while doing project appraisal, the managerial competence or talent of the promoter should be taken into
consideration.

Research studies report that most of the enterprises fall sick because of lack of managerial competence or
mismanagement. This is more so in case of small-scale enterprises where the proprietor is all in all, i.e.,
owner as well as manager. Due to his one-man show, he may be jack of all but master of none.
 PROJECT APPRAISAL TECHNIQUES

Payback Period Analysis:

This method calculates the period it will take to recover the net initial investment in the project in form of
cash flows. Investments that have a shorter payback period are considered to be less risky and on the
other hand, investments with huge payback periods are considered to be risky.

This method has certain drawbacks like it ignores factors like time value of money and net cash flows
post-recovery of the initial investment.

Accounting Rate of Return (ARR)

This method calculates the accounting rate of return by taking net annual income and dividing it by the
amount of initial investment on the project. The simplicity of the formula makes it popular, however, it
also ignores the time value of money and cash flows which are the crucial elements for any project.

Net Present Value (NPV)

By bringing all predicted future financial inflows and outflows to the present time, the net present value
(NPV) technique assesses the expected net monetary gain or loss from a project.

The NPV helps entrepreneurs to account for the time value of money when valuing long-term projects,
even when the actual worth of the project can only be determined once it is completed.

Internal Rate of Return (IRR)

The internal rate of return (IRR) calculates a project's average yearly rate of return during its lifetime. The
IRR, like the NPV, is a discounted cash flow analysis, which means it accounts for money's diminishing
worth over time. The higher a project's projected IRR is, the more desirable it is under this method.

IRR is commonly used along with NPV. That's because, depending on the initial investment outflows and
net future inflows, a project could have a low IRR yet a high NPV. This indicates that the project's rate of
return may be lower than anticipated, but its contribution to the company's overall worth is significant.
IRR will also give short projects a better ranking, undervaluing projects that repay their worth over the
long term.
 BENEFIT COST RATIO

The benefit cost ratio (or benefit-to-cost ratio) compares the present value of all benefits with that of the
cost and investments of a project or investment. These benefits and costs are treated as monetary cash
flows or their equivalents, e.g. for non-monetary benefits or company-internal costs.

Its meaning depends on the value it is indicating. For the interpretation, refer to the following 3 generic
ranges of BCR values:

Value Range of Benefit Cost Ratio Generic Interpretation

BCR < 1 Investment option generates losses.
BCR = 1 Investment option is neither profitable nor lossy.
BCR > 1 Investment option is profitable

Advantages and Disadvantages of the Benefit-to-Cost Ratio

Pros

 The BCR translates the absolute amounts of benefits and costs into a ratio
 It facilitates the comparison of different investment or project alternatives
 The ratio helps interpret the ‘inherent riskiness’ of forecasted net cash flows and profitability, e.g.
in cases where small profit margins are prone to a higher risk while large margins offer a buffer
for price adjustments
 It considers the value of cash flows in relation to the time of their occurrence
Cons

 The BCR alone does not indicate the liquidity / funding aspects of the analyzed options, e.g. an
option may require large investments and expenses in earlier periods while producing returns in
far later stages
 It is subject to various assumptions for the discount rate, residual value and cash flow forecast.
These assumptions can significantly impact the outcome of a benefit cost analysis without
considering the inherent insecurities of these parameters.
How Is the Benefit Cost Ratio Calculated?

The BCR Formula

The benefit cost ratio is calculated by dividing the present value of benefits by that of costs and
investments.
where:
BCR = Benefit Cost Ratio
PV = Present Value
CF = Cash Flow of a period (classified as benefit and cost, respectively)
i = Discount Rate or Interest Rate
N = Total Number of Periods
t = Period in which the Cash Flows occur

Note that in this formula, both present values need to be inserted with their absolute, non-negative
amounts. If you have consistently used negative cash flows for either the cost or the benefit side, your
result will be negative. You will then need to multiply it with (-1).

Components of the BCR Formula

The Formula for calculating the benefit cost ratio consists of three components: The present value of all
benefits, the present value of all costs and, finally, the division of these present values. We will discuss
them in this subsection.

1. Present Value of Benefits

The present value of benefits is calculated as the sum of discounted benefits. To determine this sum, all
inflows in a period (i.e. cash flows considered as benefits) need to be discounted with 1 plus the discount
rate i to the power of the period. This calculation needs to be performed for every period.

2. Present Value of Cost

The present value of costs is calculated analogously that of the benefits. The difference is that for this
figure, the outflows are considered as representing costs, rather than the inflows.
3. Ratio of Both Present Values

To calculate the BCR, the present value of benefits is divided by the present value of costs. Thereby, both
amounts should be absolute, i.e. non-negative.

Input Parameters and Assumptions

The calculation of the BCR requires 3 input parameters for each period:

 cash flows (benefits),

 cash flows (costs), and
 interest or discount rate.
Cash Flows (Benefits and Costs)

The cash flows used for calculating the benefit cost ratio are typically monetary values stemming from a
business forecast. Where benefits do not materialize in the form of monetary cash flows, an equivalent
should be used. Otherwise, this indicator is not applicable to the particular type of analysis.

Cash flows need to be estimated separately for benefits and costs. Benefits include but are not limited to
revenue, sales, savings, increases of values of assets, interest payments received, etc.

Examples of cost cash flows are the initial investments, expenses for the creation of products or results,
administrative costs, disposal costs, etc.

You might also consider a residual value at the end of the projection’s time horizon, which may be the
expected market value (benefit), disposal cost (a cost cash flow) or the present value of a perpetuity, an
infinite series of cash flows. If you use the latter, make sure you split the infinite cash flows into cost and
benefits and discount each group of cash flows separately.

Discount Rate

Define the discount or interest rate of your BCR analysis. It can represent the capital cost or target return
rates of your organization (often used for assessment of projects) or a risk-adjusted market interest rate.

If a detailed calculation is required, you may consider using different interest rates among the projection
period or applying different risk-adjusted rates to certain types of costs and benefits.
 SOCIAL COST BENEFIT ANALYSIS

The primary goal of all businesses is to get maximum return on investments. Thus, the promoters prefer
to assess commercial viability. However, some ventures may not give appealing results for business
profitability, so such programs are executed because they have social consequences. These are
infrastructure works, including roadway, rail, bridges, and certain other construction works, irrigation,
electricity initiatives, etc., that have a major role in socio-economic concerns instead of merely
commercial prosperity. Therefore, such initiatives are assessed for the net socio-economic advantages and
cost control that is nothing other than the national survey of potential socio-economic costs.

So, SCBA, often known as Social Cost-Benefit Analysis in project management, has become a tool for
effective financial evaluation. It is an approach to assessing infrastructure investments from a social (or
economic) perspective. Get to know more from PMP training, which is the most prominent credential
in project planning worldwide

It is a technique used for determining the value of money, specifically public investments, and it is
becoming extremely popular. In addition, it helps in decision-making regarding the numerous parts of the
organization and closely related project design programs.

The social cost benefit analysis is a tool for evaluating the value of money, particularly of public
investments in many economies. It aids in decision making with respect to the various aspects of a project
and the design programmes of closely interrelated project. Social cost benefit analysis has become
important among economists and consultants in recent years.

Features of Social Cost Benefit Analysis

1. Assess the viability of a project for the public and not for shareholders.
2. Identification of costs and benefits
3. Measurement of costs and benefits
4. The effect of (risk and uncertainty) time in investment appraisal
5. Presentation of results – the investment criterion.

Benefits of SCBA in Project Management

Social cost-benefit analysis in project management enables a complete comparison of several project
options. This is not merely a financial concern. Even so, an SCBA recognizes non-financial consequences
as well. For instance, consider the effects of increased accessibility on the environment, the economy,
and other factors.

Social cost-benefit analysis helps governments to pursue innovative initiatives that benefit all, not just a
selected few. Additionally, it aids in the entire development of an economy by assisting in decision-
making that increases job, investment, savings, and consumption, increasing a country's economic
activity.
Social cost advantages can be used for both investments. Thus, public investment is vital for a
developing nation's economic progress.

1. Market Instability

A private corporation would evaluate a deal based on productivity and relevant market prices. However,
the government must consider additional variables. Determining social costs in the event of market
inefficiency and when market pricing cannot specify them. These hidden social costs are referred to as
shadow prices.

2. Investments & Savings

A venture that results in increased savings is considered an investment in a market.

3. Income is distributed and redistributed

The initiative should not lead to revenue accumulation in the control of a few and the distribution of
income.

4. Career and Living Standards

The impact of a program on employment and level of livelihood will also be considered. Therefore, the
contract should result in a rise in employment and living standards.

5. Externalities

Externalities can be detrimental and advantageous to an enterprise. As a result, both impacts must be
considered before approving a deal. For example, positive externalities can take the shape of
technological advances, while negative externalities might take the form of rapid urbanization and
ecological degradation.

6. Subsidy and Taxation

Taxation and subsidies are treated as expenses and revenue, respectively. However, taxation and
subsidy are regarded as transfer payments for social cost-benefit analysis.

Scope of SCBA

SCBA's purpose is to establish the financial benefits of each venture in perspective of shadow prices
because initiatives impact people's savings and investments and the development's impact on the
revenue sharing in society. Additionally, it is critical to consider how certain factors like employment and
self-sufficiency will be achieved if the strategy is delivered.

SCBA can be used to engage both in the public and private sectors.
1. Public investment: conducting social cost analysis for economic infrastructure development is critical
for the developing world. When the national government contributes to shaping that country's
economy, it is essential to analyze the development's social impact.

2. Private investment: Evaluating the social impact of private development initiatives is vital as federal
and quasi-government authorities authorize these initiatives.

Different Approaches of SCBA in Project Management

By the late 1960s and early 1970s, two distinct approaches to SCBA had developed. These are as follows:
1. UNIDO's Approach 2. L-M Approach. If you're seeking an online program for the PMP certification
exam that includes thousands of PMP practice questions, the PMP Course Online package is a good
alternative.

1. UNIDO's Approach

The UNIDO (United Nations Industrial Development Organization) planning methodology is as follows:
The UNIDO method was reflected in the project assessment principles, establishing a systematic
assessment for SCBA in developing economies. However, due to the severity and complexity of this task,
concise and functional guidance for project evaluation in execution was required. Therefore, the
fundamental principle of the method is the introduction in 1978 of the UNIDO Guidance to Practical
Project Assessment.

The appraisal process is carried out on both planned and completed projects. It is a systematic method
for determining the feasibility of a project or idea. It helps determine the feasibility before allocating
funds to it. It frequently entails an evaluation of various scenarios, which is accomplished by applying
any decision procedure or financial evaluation criteria.

The UNIDO project evaluation technique consists of five phases:

1. Assessment of the proposal's market performance at market values.

2. Determining the net benefit from a financial perspective.
3. Adaptation to account for the development's implications on savings and investment.
4. Adaptation to account for the program's impacts on wealth distribution.
5. Modifying the program's results on merit products with a social worth is not equivalent to their
economic importance.

2. L-M (Little-Mirrlees) Approach

I.M.D. Little and J.A. Mirlees pioneered this technique in social cost-benefit analysis. The essential
principle of this method is that in developing countries, the social cost of using a product varies
significantly from the amount charged for it. As a result, Shadow Prices are required to signify the actual
worth of a resource to the community. The LM Strategy covers all aspects of SCBA in developing nations.
L-M Numeraire is a source of uncommitted public revenue at the moment. A project's resources – inputs
and outputs – are categorized primarily as labor traded goods and non-traded interests. As a result, to
determine the actual value of such sources, we must choose –

Shadow Wage Rate (SWR)

The SWR is used to calculate the potential cost of adding a person to the assignment. This requires us to
ascertain -

 The value of production is lost as a result of the usage of a unit of labor.

 The expense of extra consumption owing to labor transfer

Traded Goods Shadow Pricing

The shadow pricing of traded items is simply the cost at the international market.

 If a commodity is shipped, its fob price serves as the shadow pricing;

 When goods are imported, their shadow price is equal to their CIF price.

Non-traded Goods' Shadow Pricing

Non-traded commodities are those that do not access international trade. (– for example, land,
construction, and logistics). As a result, they have no noticeable border pricing.

UNIDO vs L-M Approach

UNIDO's approach is widespread in the country, whereas the L-M system incorporates international
issues as well. The UNIDO methodology prioritizes efficiency, cost reductions, and redistribution at
various levels. The L-M methodology, on the other hand, views these features in parallel.

Limitations of Social Cost Benefit Analysis

Social cost benefit analysis suffer from the following limitations.

1. The problems of qualification and measurement of social costs and benefits are formidable. This is
because many of these costs and benefits are intangible and their evaluation in terms of money is bound
to be subjective.
2. Evaluation of social costs and benefits has been completed for one project, it may be difficult to judge
whether any other project would yield better results from the social point of view.
3. The nature of inputs and outputs of projects involving very large investment and their impact on the
ecology and people of the particular region and the country as a whole are bound to be differing from
case to case.
 RISK ANALYSIS

Risk we mean a situation in which the possible future outcome of a present decision is plural and in which
the probabilities and dimensions of their outcomes are known in the form of a frequency distribution.
Risk refers to variability. It is measured in financial analysis generally by standard deviation or by beta
coefficient. Technically risk can be defined as a situation where the possible consequences of the decision
that is to be taken are known.

Risk is composed of the demands that bring in variations in return of income. The main forces
contributing to risk are price and interest. Risk is also influenced by external and internal considerations.
External risks are uncontrollable and broadly affect the investments.

RISK ANALYSIS

Risk analysis in project management refers to an important aspect of the feasibility study wherein various
risks and uncertainties are identified in order to evaluate them, rank them in terms of priority and identify
the areas where they are most likely to occur.
Risk Analysis is a series of activities to quantify the impact of uncertainty on a project. These activities
are risk identification, probability assessment, and impact estimation. Risk analysis creates the foundation
for running the risk management process throughout the project lifecycle.
In project management, risk analysis is conducted to screen the risks and uncertainties that may affect the
project and its components. This is done in the early stages of a project; usually after an initial feasibility
study process. The primary reason for analyzing project risks at this stage is to prevent them from
becoming significant at a later stage.
In this article, we look at how to perform risk analysis in project management. We will take into
consideration risks that may affect a project and its components; those that may financially impact the
project and those that may cause delays in the completion of a project. We will also consider which risks
can be managed effectively.

In project management, a risk is described as a combination of the following elements:

Risk = Potential Negative Event + Impact + Probability of Occurrence

The probability of risk occurrence ranges from 0% to 100%. It is important to note that risk probabilities
are not fixed and can change at any time throughout the project life-cycle.

Factors that affect the probability of occurrence include:

 The experience and skills of the project team

 The complexity of the task
 The existence of similar tasks in the past
  Change control procedures
 External variables

Three types of risk analysis

1. Qualitative Risk Analysis. It is a subjective analysis by the project team where risks are identified
and assessed based on their probability of occurrence. The risk analysis table lists the risks in terms of
their probability of occurrence, impact and its control strategies.
2. Quantitative Risk Analysis. It is an objective analysis wherein risks are classified according to their
probability of occurrence, using the standard deviation to determine its level. This technique is useful
for determining the impact of risk events to project objectives and for identifying the possible courses
of action and methods for controlling and mitigating risks.
3. Technical Risk Analysis. it is a dynamic analysis that requires the project manager to use various
tools and techniques in order to identify, rank and evaluate risks. For example, the Delphi method
requires the project manager to present the risks to a group of experts in the field and ask them to rate
or rank each risk in terms of its probability.

RISK ANALYSIS MANAGEMENT

The goal of risk analysis management is to identify and estimate the value of potential threats and then
choose what approaches to apply to respond to identified risks. Risk analysis management consists of
three coherent activities

1.Threats Identification. This activity is about identifying all potential events that seem to be
risky for the project. The next tasks characterize this activity:

 Conduct workshops and use brainstorming to determine types of the risks surrounding your
project. There could be Strategic risks, Operational risks, Compliance risks, Staff management
risks, Financial risks, Knowledge risks, etc.
 List all the types of risks affecting the project (create a project risks list sorted by types).

2.Probability Assessment. Once the potential threats have been identified, the next activity is to measure
the probability of those threats for occurrence. The goal is to estimate the probability of each event
happening during the project.
 Investigate each of the identified risks to create a detailed description of the risks.
 Use the project risk description to make an evaluation on how the risks may cause a project
failure considering Budget, Completion Dates, and Performance Objectives.
 Apply analysis methods and techniques (e.g. PERT – Program Evaluation and Review Technique)
to identify the probability of risk occurrence and assess potential deviations of project
characteristics from the baseline.
3.Impact Estimation. One of the best approaches to estimating risk impact is to multiply the probability
of risk occurrence by the amount of costs required for setting things right if risks happen. The result will
give a value for the identified risks. Following this concept, the next tasks should be completed:
 Use the formula ∑ (Events * Probability * Consequences) to estimate the impact of the risks
affecting your project.
 Develop a risk analysis table that includes such columns as Risk Event, Probability, Impact, Score,
and Risk Mitigation Plan. The table demonstrates results of the risk analysis management process
with details on risk characteristics and mitigation plans. An example of the risk analysis table is
shown below.

Managing of project risk analysis can be performed by using:

 Available assets. Any project has resources available for solving risk issues. Such resources can be
used to make improvements to existing methodologies and systems, reassign roles and responsibilities,
delegate tasks, improve internal controls and supervision, etc.
 Contingency planning. This involves the development of a contingency plan. Contingency planning
assumes acceptance of a risk with further implementation of a contingency plan to minimize or
eliminate the negative impact of the risk (once it happens).
 External resources. The process of managing project analysis sometimes requires additional
resources when existing assets are not enough for solving project issues. In this case, investments will
help counter risks. Often project risk insuring is used to carry part of the risks. Project risk insuring is
an effective way to increase solvency of the performing organization.

PROJECT RISK MANAGEMENT PLAN

Risk Management Plan

A risk management plan provides a framework for performing project risk analysis. It requires that you
define certain terms, methods and procedures that will be used to perform the tasks of the analysis.

The main components of a project risk management plan are:

 Definition of the business processes of your project.

 Selection of risks’ types, including which ones are most important to pay attention to.
 A list of the potential risks, probability and impact assessment based on already-made risk analysis.
 The identification and prioritization of mitigation strategy options for each identified risk, that is to
say, what actions need to be carried out in order to prevent that risk coming into existence or reduce its
extent.
 The list of the main risks’ sources.
 The definition of the control actions intended to reduce the number of risks, their frequency or impact
assessment.
 The definition of mechanisms for monitoring and reporting on the status of risks, including reporting
frequency and distribution channels.
 Procedures for information exchange between all stakeholders involved in risk management.

TYPES OF RISK:
1. Systematic Risk:
Market risk, interest rate risk and purchasing power risk are grouped under systematic risk.

They are explained as under:

(i) Market Risk:
It is referred to as stock variability due to changes in investor’s attitudes and expectations. The investor’s
reaction towards tangible and intangible events is the chief cause affecting market risk. Market risk
cannot be eliminated but it can be reduced. Market risk includes such factors as business recessions,
depressions and long term changes in consumption in the economy.

(ii) Interest Rate Risk:

There are four types of movements in prices of stocks in the market. These may be termed as long term,
cyclical, intermediate and short term. Traditionally, investors could attempt to forecast cyclical savings in
interest rates and prices merely by forecasting ups and downs in general business activity.

The effect of interest rate can be different for lending institution and borrowing institution. In India, a
combination of factors have produced a situation where it is difficult to accurately find out the changes in
interest rates.

(iii) Purchasing Power Risk:

It is also known as inflation risk. It arises out of changes in the prices of goods and services and
technically it covers both inflation and deflation periods. In India, purchasing power risk is associated
with inflation and rising prices. All investors should have an approximate estimate in their minds before
investing their funds of the expected return after making an allowance for purchasing power risk.

2. Unsystematic Risk:
It arises out of the uncertainty surrounding a particular firm or industry due to factors like labour strike,
consumer preferences and management policies.

The two kinds of unsystematic risks in a business organisation are business risk and financial risk
which are explained below:
(i) Business Risk:
Every firm has its own objectives and aims at a particular gross profit and operating income. It also hopes
to plough back some profits. Business risk is also classified into internal business risk and external
business risk. Internal business risk may be represented by a firm’s limiting environment within which it
conducts its business. External risks are due to many factors and some of the important factors are
business cycle, demographic factors, political policies, monetary policy and the economic environment of
the economy.

(ii) Financial Risk:

It is associated with the method through which it plans its financial structure. If the capital structure of a
company tends to make earnings unstable, the company may fail financially. Large amounts of debt
financing also increase the risk. Financial risk can be stated as being between Earnings before Interest and
Taxes, and Earnings Before Taxes.

Measurement of Risk:
A number of techniques have been suggested by economists to deal with risk in investment appraisal.

Some of the popular techniques used for this purpose are as follows:
1. Risk Adjusted Discount Rate Method:
This method calls for adjusting the discount rate to reflect the degree of the risk of the project. The risk
adjusted discount rate is based on the presumption that investors expect a higher rate of return on risky
projects as compared to less risky projects.

The rate requires determination of (i) risk free rates and (ii) risk premium rate. Risk free rate is the rate at
which the future cash inflows should be discounted. Risk premium rate is the extra return expected by the
investor over the normal rate.

The adjusted discount rate is a composite discount rate. It takes into account both time and risk factors.

Illustration:
A project with an outlay of Rs. 4,00,000, its risk adjusted discount rate is estimated at 18 per cent.
The data on cash flow is as follows:
Should the project be accepted or rejected?

Accept the project: if NPV > 1

Reject the project: if NPV < 1

Using the risk adjusted discount rate we find that

2. The Certainty Equivalent Approach:

According to this method, the estimated cash flows are reduced to a conservative level by applying a
correction factor termed as certainty equivalent coefficient. The correction factor is the ratio of riskless
cash flow to risky cash flow.

The certainty equivalent coefficient which reflects the management’s attitude towards risk is

Certainty Equivalent Coefficient = Riskless Cash Flow/Risky Cash Flow

Example:
A project is expected to generate a cash of Rs. 40,000. The project is risky but management feels that it
will get at least a cash flow of Rs. 24,000. It means that certainty equivalent coefficient is 0.6.

Under the certainty equivalent method the net present value is calculated as:

Where

αt = Certainty Equivalent Coefficient

At = Expected Cash Flow for year t
I = Initial outlay on the project

i = Discount rate
Illustration:
Pioneer Concern is considering a project with initial outlay of Rs. 18,00,000 with a risk free discount rate
of 1.05 per cent. The expected cash flow and certainty equivalent coefficient are given below. What is
NPV of the project?

3. Sensitivity Analysis:
The future is not certain and involves uncertainties and risk, the cost and benefits projected over the
lifetime of the project may turn out to be different. This deviation has an important bearing on the
selection of a project.

If the project can stand the test of changes in the future, affecting costs and benefits, the project would
qualify for selection. The technique to find out this strength of the project is covered under the sensitivity
analysis of the project. This analysis tries to avoid over estimation or underestimation of the cost and
benefits of the project.

In sensitivity analysis, we try to find out the critical elements which have a vital bearing on the costs or
benefits of the project. In investment decision, one has to consider as many elements of uncertainty as
possible on costs or benefits side and then arrive at critical elements which effect the expected costs or
benefits of the project.

How many variables should be tested to carry out the sensitivity analysis in order to find out its impact on
costs or benefits of the projects is a matter of judgement. In sensitivity analysis, one has to consider the
changes in the various factors correlated with changes in the other. In order to arrive at the degree of
uncertainty, the decision maker has to make alternative calculation of costs or benefits of the project.

Sensitivity analysis is a simulation technique in which key variables are changes and the resulting change
in the rate of return is observed. Some of the key variables are cost, prices, project life, market share, etc.
Usually this analysis provides information about cash flows under the assumptions:
(i) Pessimistic,

(ii) Most likely, and

(iii) Optimistic.

It explains how sensitive the cash flows are under these three different situations. If the difference is
larger between the optimistic and pessimistic cash flows, the more risky is the project.

Illustration:
Pioneer Company Ltd. is attempting to evaluate two projects A and B. Each project requires a net
investment of Rs. 10,000 and the annual cash flows from each of the project is estimated at Rs. 2,000 p.a.
in the next 15 years. The company’s cost of capital may be taken at 10%. In order to arrive at a decision
about the selection of the project, the following data have been ascertained regarding the NPV of cash
flows of each project.

4. Probability Theory Approach:

Yet another method for dealing with risks is to estimate the value for a result. Each value of prospective
result is assigned a probability. Here one has to see a range of possible cash flows from the most
optimistic to the most pessimistic for each pertinent year. Probability means the likelihood of happening
an event.
It may be objective or subjective. An objective probability is based on a large number of observations
under independent and identical conditions repeated over a period of time. A subjective probability is
based on personal judgement. In capital budgeting decisions the probabilities are of a subjective type
since they are based on a single event.

Process of Assigning Probabilities:

Here let us see the process of assigning probabilities.

It is subject to certain rules and they are:

(i) List of events collectively expansive

(ii) Events must be mutually exclusive

(iii) The numerical probabilities must add up to 1.

Basic Probability Theorem:

We must see certain basic theorems relating to a probability theory.

These are as follows:

(i) The probability of an event is always a number between 0 and 1 inclusive. If an event is sure to occur,
its probability is by definition equal to 1. If it is certain that it will not occur its probability is 0.

(ii) If ‘n’ events are equally likely and only one of them may happen, then the probability of that event is
1/n.

(iii) If two events are mutually independent and the probabilities of one is PI while that of other P2, the
probability of the events occurring together is the product of P1, P2.

(iv) If the events are mutually exclusive and the probability of the one is PI while that of the other is P2,
the probability of either one or the other occurring is the sum P1+P2.

Illustration:
Pioneer Company Ltd. has given the following possible cash inflows for two of their projects A and B.
Both the projects will require an equal investment of Rs. 5,000. Let us compute expected monetary values
for the projects A and B.
The above table shows that Project B has higher monetary value as compared to Project A. Therefore,
Project B is preferable.

5. Standard Deviation:
Subjective judgment of the decision makers plays a crucial role in practice to resolve the problem which
may turn out to be imprecise or biased. There is no precise way to find the probabilities of different
outcomes. This limitation is overcome by adoption of standard deviation approach.

The standard deviation is defined as the square root of the mean of the squared deviations of all the items
from the mean and it is usual to denote it by the small Greek “Sigma”, σ. In the case of capital budgeting,
this measure is used to compare the variability of possible cash flows of different projects from their
respective mean or expected values.

Steps to be followed for calculating the S.D. of the possible cash flows:
(i) Compute the mean value of the possible cash flows.

(ii) Find out the deviation between the mean value and the possible cash flows.

(iii) Square the deviations.

(iv) Multiply the squared deviations by the assigned probabilities to get the weighted squared deviations.

(v) The sum of the weighted squared deviations and their square root are calculated. The result gives the
S.D.

Illustration:
On the basis of the data given in probability theory approach find out which project is more risky by
adopting S.D. approach.
A project having a larger standard deviation will be more risky as compared to a project having smaller
standard deviation. In the above illustration, the standard deviation for project A is 1,095 while that of
project B is 2,098. Hence project B is more risky.

6. Coefficient of Variation:
Standard deviation is expressed in the units of the original distribution and is called absolute measure of
dispersion. Therefore, absolute measure must be reduced to a form which is free from the original unit of
measurement. This can be done by expressing it in relation to the average from which variation is
measured. This measure of relative variation is obtained by dividing the absolute measure by that average
and is called a coefficient of variation.

The co-efficient of variation can be calculated as follows:

Coefficient of Variation = Standard Deviation/Expected (or Mean) Cash Flow = σ/Erf

On the basis of the data given in the standard deviation approach, the standard deviation for project A is
1095, while that for project B is 2098. The coefficient of variation of project B is more as compared to
project A. Hence project B is more risky.
7. Decision Tree Analysis:
The decision tree analysis is another technique which is helpful in tackling risky capital investment
proposals. A decision tree is a graphic display of various decision alternatives and the sequence of events
as if they were branches of a tree.

In constructing a tree diagram, it is a convention to use the symbol □ to indicate the decision point and O
denotes the situation of uncertainty or event. Branches coming out of a decision point are nothing but
representation of immediate mutually exclusive alternative options open to the decision maker.

Branches emanating from the event point ‘O’ represent all possible situations. These events are not fully
under the control of the decision maker and may represent some other factors. The basic advantage of a
tree diagram is that another act subsequent to the happening of each event may also be represented. The
resulting pay-off for each act-event combination may be indicated in the tree diagram at the outer end of
each branch.

Construction of Decision Tree:

The construction of a decision tree requires definition of proposal, identification of alternatives, graphing
the decision tree, forecasting cash flows, and evaluating results.

This process can be undertaken in the following way:

(i) The first step in the construction of the decision tree is the definition of proposal. It means what is
exactly required under the proposal.

(ii) The second step in the decision tree is the identification of alternatives. Each proposal will have at
least two alternatives—accept or reject. In some cases, there may be more than two alternatives too.

(iii) The third step is graphing the decision tree. Decision tree is a graphical method. It visually helps the
decision maker view his alternatives and outcomes.

Illustration of a Decision Tree Diagram:

(iv) The fourth step is forecasting cash flows. The forecasted cash flows regarding each decision branch
are also shown along with the branch. Probabilities are also assigned to each cash flow. The probabilities
of each event will be different.

(v) The fifth step in construction of a decision tree is evaluating results. The evaluation will be based on
manager’s own experience, consultation with others and information available in this respect. On the
basis of the expected value for each decision, the results are analysed. The firm may proceed with
profitable alternative.

The pay-off for ultimate alternatives has been calculated by taking into account the probabilities of the
ultimate alternative as well as for the previous alternative and multiplied by the expected pay-off of the
first alternative without its probability. By incorporating probabilities of various events in the decision
tree, it is possible to comprehend and trace probability of a decision leading to results desired.

What is significant about the decision tree approach is that it does several things for decision makers. It is
highly useful to a decision maker in multi-stage situations which involve a series of decisions each
dependent on the preceding one. It makes possible for them to see at least the major alternatives open to
them and that the subsequent decisions may depend on events of the future.
 SENSITIVITY ANALYSIS
Project sensitivity is a holistic evaluation of how likely it is that a project will succeed through data-
driven forecasting. It also identifies risks, quantifies their impact, and separates high-risk tasks from low
ones. Project sensitivity is defined by both a written analysis and a mathematical formula that includes
average task durations based on past data, simulated durations based on hypothetical models, and an
average task duration for both of those projections.

Project sensitivity refers to the project as a whole however key phases or components of the project (like
scheduling) can also have their own sensitivity analysis. Project sensitivity is primarily used to choose the
right approach or solution to the project’s main problems.

SENSITIVITY ANALYSIS IN PROJECT MANAGEMENT

Sensitivity analysis in project management (also known as a risk and sensitivity analysis in project
management) is a method for modeling risk in any given assignment. Project sensitivity looks at the big
picture to see what, out of all the elements involved, could potentially prevent you from achieving your
goal or goals.

It also ranks these threats by order of importance from most to least impactful. Then, it’s up to you and
your team to prevent these issues from either coming up or derailing progress.

Difference between a cost-benefits analysis and a sensitivity analysis

A cost-benefits analysis is used to estimate the pros and cons of alternative solutions for a project. A
sensitivity analysis determines which of these solutions is the most viable given what we know about the
rest of the project. A sensitivity analysis is often used to support a cost-benefits analysis, but can also be
done independently.

There are a number of key steps involved in making your own project sensitivity analysis. These include:

1. List project elements that impact net present value (NPV) or internal rate of return
(IRR): Include the material costs, freelancer project estimates, overhead costs, and any other
major area susceptible to change once the project is up and running. You should also include
fixed expenses in case they go out of stock, cost more than what was originally agreed on, or are
subject to market demand. For example, in a construction project, you may need twice as many
building materials as you originally thought once contractors have begun working on the
foundation.

2. Write an analysis of all project element dependencies: Project elements might cost more,
become obsolete, or become redundant if one or more of the other elements change. List out all
the elements then compare the list to one individual element at a time to see what happens to its
duration, cost, and effectiveness whenever another element is affected.

3. Determine how each of your dependencies affect the NPV: Compare each detailed dependency
against your NPV to determine which will make the most significant difference.
 Project sensitivity analysis example

If Company A manufactures dolls, a newly-added 2% processing fee from their third-party stuffing
wholesaler may create a 5% change in NPV to accommodate the increased expense. Although you can’t
plan for every possible scenario, a project sensitivity analysis can help you navigate the foreseeable future
and develop contingency plans for these and other issues before they come up.

As a project manager, you make important decisions every day. But how can you be sure that the choices
you’re making are the best ones for both your individual career and your company as a whole? The
answer is found through decision tree analysis.

In this article, you’ll learn exactly what decision tree analysis is and why this exercise can be so beneficial
for project managers. We’ll then show you a four-step system you can use to make effective decision
trees. Let’s dive in!

SIMULATION ANALYSIS
Definition: The Simulation Analysis is a method, wherein the infinite calculations are made to obtain
the possible outcomes and probabilities for any choice of action.

Project management simulation is used to analyze real projects. The goal of the simulation is to show
the user the different possible outcomes of his decisions, along with the probability that each outcome
will occur. The simulation helps in reducing the project risk and in choosing the best project plan.

The concept of simulation analysis can be further comprehended through the following steps:

1. The first step is to model the project. A model shows how the net present value is related to the
parameters and the exogenous variables. The parameters are the variables specified by the decision maker
and are held constant throughout the simulation, whereas the exogenous variables are randomly
determined and are beyond the control of the decision maker.
2. The next step is to specify the values of the parameters and assign probabilities to the random variables
that arise from the external factors.
3. Randomly, select any value from the probability distribution of each of the exogenous variables.
4. Compute the NPV for both the randomly generated values of exogenous variables and the parameter
values, as specified by the decision maker.
5. Repeat the step 3 and 4 again and again, to get a large number of simulated values of NPV.
This whole process of simulation analysis compels the decision maker to consider all the
interdependencies and uncertainties characterizing the project. Thus, the viability of the project is
determined on the basis of number of outcomes and the probabilities realized through a series of actions
performed during the simulation analysis
 DECISION TREE
A decision tree is a type of diagram that clearly defines potential outcomes for a collection of related
choices. In project management, a decision tree analysis exercise will allow project leaders to easily
compare different courses of action against each other and evaluate the risks, probabilities of success, and
potential benefits associated with each.

It’s important to note that a proper decision tree has four main elements: decision nodes, chance
nodes, end nodes, and branches. Let’s briefly explore each of these individually.

Decision Nodes: A decision node, represented on our decision tree diagram as a square, indicates a choice
that needs to be made.

Chance Nodes: A circle represents a chance node and is used to signify uncertain outcomes. These nodes
are used when future results are not guaranteed.

End Nodes: End nodes, like the name suggests, represent the end of a diagram and illustrates a final
outcome.

Branches: Lastly, we have branches. Branches are what connect the nodes together. Each branch
represents a potential choice and should be clearly labeled.

In general, a decision tree analysis exercise begins with a single decision node, AKA a square. From
there, branches are drawn representing various choices and resulting in potential outcomes (i.e. chance
nodes).

When the full potential scenario has been played out, an end node is used to signify the final outcome. As
you’ll see later in this article, a completed decision tree analysis graph looks like a tree, hence the name.

Benefits of Decision Tree Analysis

As a project manager, every decision you make presents both new threats and fresh opportunities. The
decision tree analysis technique allows you to be better prepare for each eventuality and make the most
informed choices for each stage of your projects.

There are other benefits as well:

Clarity: Decision trees are extremely easy to understand and follow. When structured correctly, each
choice and resulting potential outcome flow logically into each other.

Efficiency: Building off the last point, because decision trees present information in such a
straightforward way, they can be quickly analyzed and used to make crucial decisions.

Adaptability: Decision trees can be easily adapted to accommodate new ideas and/or opportunities.
Meaning, your tree can grow alongside your projects.

Compatibility: The decision tree analysis technique can be used in tandem with other project
management methodologies, allowing you complete flexibility as you manage your projects.
STEPS IN A DECISION TREE PROJECT

In order to correctly conduct a decision tree analysis, you must follow these 4 steps:

1. Lay out all your options

The first thing to do is to identity all the options you have to complete your project. Indeed, there are
always several ways to get the result you need, but some of them are quicker and more effective than
others. The decision tree will help you recognize the best course of action, but first you need to make sure
that you have included all the existing options.

2. Predict potential outcomes

Now that you’ve got all your options laid out, you need to evaluate the results that each option will bring.
Projecting yourself in the future is never easy and your projections most probably won’t be totally
accurate. Nevertheless, it is important to give it your best effort so that the conclusions of your decision
tree analysis are as reliable as possible.

3. Analyze the results

By now, your decision tree contains all the branches representing your different options with the
outcomes you predicted. So the next step is the analysis part. Analyze each one of the results presented in
the decision tree. By taking into account the limitations and objectives of your project, determine how
acceptable the different outcomes are.

4. Optimize your decisions

Finally, you should optimize your decisions. This means determining which option will best fit your
project. The decision tree you have created should by now present all the possible choices and their
outcomes in a clear and visual way. Use it to decide which option has the biggest probability of success
and the greatest benefits