Project Management- Managerial Appraisal

Saturday,October 04, 2008 Prepared By: GAURAV SEHGAL 1
PROJECT MANAGEMENT

“The process of financial appraisal & financial control is shaped by
the conditionality in the form of what is Certainty & what is not-a-
certainty.”
The above statement lays emphasis on the deficiency of the financial
appraisal which is based mostly on the colorful projections rather than pure &
factual information.
Such financial bollix and its aftermath on the decision-making might nauseate
the overall project appraisal. As every project is a creation or a visible
expression of a desired change, it demands a clear perception of the future
both in terms of opportunities & threats.
As noted J.M.keynes laments on this situation as – “the outstanding fact is the
extreme precariousness of the basis of knowledge on which our estimates of
prospective yield to be made. Our knowledge of the factors which will govern
the yield of an investment some years hence is usually very little & often
negligible. If we speak frankly, we have to admit that our basis of knowledge for
estimating the yield ten years hence of a railway, a copper mine, a textile
factory, the goodwill of a patent medicine, an Atlantic liner, a building in a City
of London, amounts a little and sometimes nothing.”
Therefore, it is crystal clear that uncertainty is an undeniable fact of every
project. The smaller the project-the smaller will be the risk of uncertainty &
the greater the project-the more serious would be the blighted hope.

Some of the important risk factors which can be associated with complex
projects of today are as follows,
 Identification risks;
 Objective or Criteria risks;
 Project planning risks;
 Technological risks;
 Engineering risks;
 Construction or Manufacturing risks;
 Acceptance risks;
 Currency exchange risks;
 Liability risks;
 Training & project operations risk;
 Procurement risks;
 Maintenance risks; and
 Risk of obsolescence.
These risks are confronted while meeting the schedules, changing the
financial terms, facing shortfall in revenues or benefits, and other regulations
& jurisdiction over the project that are dynamic in nature.

PROJECT RISKS CLASSIFIED
Distinctively each project is prone to several kind of risks, and
they are classified as follows,
 Measurable Risks – risks which can be measured in terms of a
probability coefficient related to each possible situation. For
example, economic activities, subject to climatic variations
are uncertain but can be known in terms of probability.
 Immeasurable Risks – risks related to a future situation which
cannot be measured in terms of probability, but depends on a
single event or a limited number of events, such as, the
success or failure of political negotiations, the result of
elections, scientific discovery, & so on so forth.

 Manageable Risks – risks due to ordinary mistakes in estimates or
forecasts at the planning stage. They can occur both in forecasts of
demand & prices, and in estimates of costs.
 Insurable Risks – these risks are associated with misfortunes
having a statistical history, such as, accidents, fires, losses & many
such mishaps. The whole insurance industry is built around these
risks & financial protection against them can be bought. Some risks
are preventive & some are not.
 Investment Risks – these are associated with decisions concerning
capital, that is, should a firm invest either money or its employee’s
time & effort in pursuing a particular project? The principal
determinant will be the expected benefit from the project against
the expected cost. Either failure to invest in time may result in loss
of the market or if invested in a wrong project or portfolio that may
also lead to heavy losses.

 Strategy Risks – these risks are associated with the choice of the
strategy to undertake a project. There are usually several ways that
a project can be executed & an examination of the risks associated
with each strategy should lead to the optimum choice. This type of
analysis could include technical risk analysis & the construction of a
plan to reduce risks of performance failure.
 Conditional Risks – these risks are associated with the conditions
that actually arise during the course of the project; they could be
different from that contained in the plan. As the future always
contain uncertainties, the chain of events & the eventual outcome
of the project cannot be stated with certainty. In these
circumstances, what may happen can only be predicted in a
statistical sense, that is, how likely it is that something might
happen.

 Completion Risks – these are the risks that focus on the mobility of a
project to get completed on time. A project may not get completed because
of technological failures, cost over-runs, force majeure or necessary
variations. If the project is delayed, interest will mount up & perhaps not be
covered by the projected cash flows. Project lenders will not be prepared to
take non-recourse completion risk & require either a completion guarantee or
a guarantee of the loans until completion provided by the project sponsors.
 Permitting Risks – these risks are associated with official licenses &
consents required for the project that have too many by-laws or are subjected
to costly conditions, in terms of construction, environmental or extractive
consents from the host government. Lenders may be reluctant to lend if the
project gets blocked or delayed due to the non-availability of a necessary
permit. Hence, the important permits cannot be left to be obtained later &
must be settled or completely assured – before non-recourse money is lent.
Some minor consents might be dealt with by drawdown milestones, but
usually the absence of a critical consent is fatal to early drawdown, that is, the
obtaining of all necessary consents is a pre-condition precedent to borrowings
under the credit agreement.

 Price Risks – these risks are born due to the volatile markets or government
price controls. They are wide ranging risks stretching from inputs to outputs
of a project. The risk is sought to be dealt with the matching of contracts &
passing to purchasers through the project output. In such circumstances,
purchasers of project output will become scapegoats. The ideal thing is that a
creditworthy purchaser should agree to pay a price for the project which
covers both costs & loans, irrespective of the results of the project.
 Resource Risks – these risks arise due to scarce resources & their reserves,
such as, gas, minerals, manpower, etc.. These are assessed by initial
evaluations performed by experts & engineers. The lenders may keep a
cushion retention account financed out of proceeds, and monitor continued
viability through coverage ratios.
 Operating Risks – these risks cover manpower costs, maintenance costs,
technology costs, operating costs, supply costs & the like. These risks are
sometimes met by passing on the extra costs to purchaser of the product,
sometimes by proceeds of retention accounts, and are monitored through
coverage ratios.

 Casualty Risks – these are also labeled as damage risks & are
usually met as far as possible by insurance in which the deductibles
& exclusions are important. These may also delay set-up of the
project & interrupt the implementation.
 Technology Risks – these risks refer to the involvement of a
sophisticated unproven technology with a likelihood of latent
defects. These risks are also assessed by expert evaluations, and by
retention accounts to cover the projected cost of maintaining the
project.
 Environmental Risks – this contemplates such matters as pollution
& clean-up costs on abandonment. These are difficult to meet
completely, but may be mitigated to some extent by an initial
environmental audit and by insurance. But one cannot cover
potential future legal changes in advance.

 Exchange Rate Risks – these risks represent fluctuations in the
local currency due to change in the foreign markets. The net impact
will be that the currency in which the project is paid gets devalued
thereby leaving a big gap between project costs & revenues. The
gap would be treated as cost overruns. This may be met by
currency swaps for other options, but it would be unusual for
currency swaps or options to be available for the whole period of
the loan (between 7 to 12 years or more), even if there is a market.
 Interest Rate – these risks constitute unanticipated or unexpected
changes in interest rates. These may be met by capping the
interest rates or by interest swap agreements. Mostly, the clause of
variation in interest rates will be provided in contracts, still to a
larger extent the rate of deviation in interest cannot be predicted
accurately. These also result in cost overruns as the total credit
increases with increase in interest rates. The credit risk of the
counterparty is an additional factor.

 Insolvency Risks – these risks arise basically due to insolvency of
contractors, project sponsors, suppliers, purchasers, insurers or a syndicate
bank. These risks are inherent to bank credits & are usually assessed by
bankers while performing initial project assessment. It is the credit worthiness
of sponsors, that play a vital note in lending & borrowing. In general, these
risks are a feature of small scale projects, but in the recent past, even public
sector projects, such as, Vizag Steel Plant are confronted with these risks due
to a variety of socio-economic reasons.
 Political Risks – these risks are related to reformulations brought under
ever-changing political interventions in the forms of regulation of taxes &
royalties, employment controls, regulating monopolistic trade practices,
encouraging exports & revocations or changes to concessions, export
prohibitions, exchange controls on proceeds, excessive environmental clean-
ups, forced governmental or local participation in shares, planning or
construction controls & the refusal of import licenses for essential foreign
equipments. The expropriations may be creeping or constructive as opposed
to an outright nationalization. Government price controls within a utility
sector falls within this area.

Some of the popular techniques applied for incorporating
risk factors in projects are,
 GeneralTechniques
 Risk Adjusted Discount Rate;
 Certainty Equivalent Coefficient.
 QuantitativeTechniques
 Sensitivity Analysis;
 Probability Distribution Method;
 Standard Deviation Method;
 Coefficient ofVariation;
 Decision Tree Analysis.
Now let us discuss all these techniques in detail,

 Risk Adjusted Discounted Rate Method.
This is based on the presumption that investors expect higher rate of
return on risky projects as compared to less risky projects. The rate
requires determination of : Risk Free Rate & Risk Premium Rate.
Risk Free Rate is the rate at which the future cash inflows should be
discounted assuming there to be no risk.
Risk Premium Rate is the extra return expected by the investor over
the normal rate (the risk free rate) on account of the project being
risky.
Thus, the Risk Adjusted Discounted Rate (RADR) is a composite
discount rate that takes into account both the time & risk factors. A
higher discount rate will be used for more risky projects and lower rate
for less risky projects.

 Certainty Equivalent Coefficient Method.
According to this method the estimated cash flows are reduced to conservative
level by applying a correction factor termed as certainty equivalent coefficient.
The correction factor is the ratio of riskless or certain cash flow to risky cash flow.
Thus,
Certainty Equivalent Coefficient (CEC) = Riskless Cash flow .
Risky Cash flow
Riskless cash flow means the cash flow which the management is prepared to
accept in case there is no risk involved. Obviously, this will be lower than the cash
flow which will be there in case the project is risky.
For instance, a project is expected to generate a cash flow of Rs. 40,000. the project is
risky but the management feels that it will get at least a cash flow of Rs. 30,000. it
means that CEC will be 0.75 (that is, 30,000/40,000).
In other words, CEC focuses on the minimum returns out of the total expected
returns.
CEC’s are computed for estimating cash flows of each year. They are then
multiplied with the cash flows to ascertain cash flows which may be used for the
purpose of determining the IRR or NPV for capital investment decisions.

 Sensitivity Analysis.
Despite the inability of the project analyst to produce a probability distribution of
present values, it is nevertheless important to furnish top management to make
the final choice with as much assistance as possible in seeing where the risks lie,
and in assessing their importance. The best practical way to do this is to select
those variables whose estimated values may contain significant errors, and then
to calculate the effect of errors of different sizes on the present value of the
project. This is known as sensitivity analysis (investigation of the sensitivity of an
expected outcome to various kinds of operational errors). When the analyst has
discovered the variables to which the outcome is more sensitive, he should:
 Scrutinize estimates of these with the greatest care;
 Discuss the estimated values in the report, and suggest possible range of
errors; &
 Present the sensitivity analysis for the use of decision making.
It should be noted that, the objective of sensitivity calculations is not only to give
an idea of change in the present value which results from wrong & inappropriate
estimates, but also to help decide on the variability of the project. Also in early
stages of the project investigation, sensitivity analysis may be used to pick out
those variables to the estimation of which the most resources & thought should
be devoted.

 Probability Distribution Method.
Ideally, the project analyst might present by applying a probability
distribution method a range of present values of each project with a
probability estimate attached to each such value. Thus, instead of expressing
in absolute terms on the computed present value of a project, a probable
range of estimations may b determined that is similar to the following,
By multiplying the outcomes with the probabilities & summing, one can then
produce the actuarial present value, in in the above case comes out to be 3.
Present value -5 0 +5 10
Probabilities 0.2 0.2 0.4 0.2

Standard Deviation Method.
The probability approach for risk analysis in capital budgeting does not provide
the decision maker with a precise value indicating about the variability of cash
flows & therefore the risk. The limitation is overcome by adoption of standard
deviation approach.
Standard deviation is a measure of dispersion. It may be defined as “ the square root of
squared deviations calculated from the mean.”
In 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. A project having a larger standard deviation will be more risky than a
project that is having a smaller standard deviation value.
The following steps are taken for computing the standard deviation of the possible
cash flows associated with a project,
 Mean value of possible cash flow is computed;
 Deviations between the mean value & the possible cash flows are found out;
 Deviations are squared;
 Squared deviations are multiplied by the assigned probabilities which gives
the weighted squared deviations; &
 The weighted squared deviations are totaled and their square root is found
out.The resulting figure is the standard deviation.

 Coefficient ofVariation.
Standard Deviation is an absolute measure. It is unfit for comparisons
particularly where projects involve different cash outlays or different
expected values (mean values). In such cases relative measure of
dispersion should be calculated. Coefficient of variation is one of such
measures.
It is calculated as follows,
Coefficient ofVariation = Standad Deviation (σ) .
Expected cash flow (Xcf)

 DecisionTree Analysis.
This is another important and widely applied technique that helps in
solving risky projects by sequentially branching out the possibilities of
success & failure. This is a graphical relationship between the present
decision & the possible future events, future decisions and their
consequences.
The sequence of events is mapped out over time in a format
resembling branches of a tree. An outstanding feature of decision tree
analysis is that it links events chronologically with forecasted
probabilities and thus gives a systematic appearance of decisions &
their expected results.

Construction of a DecisionTree:
The following steps are necessarily taken care of while constructing the
decision tree for any project,
 Definition of the proposal: for example, construction of a bridge;
 Identification of alternatives: for example, constructing the bridge
through in-house resources (men & material) or through contractors;
 Graphing the decision tree: for example, tree branches are drawn &
indicated by the probability of success and failure in both the alternatives;
 Forecasting the cash flows: for example, cost & benefits in both
alternatives are to be indicated on the branches of the tree accordingly; &
 Evaluating the results: for example, checking the probability, chances of
success & risk factors and weighing them under given conditions in order
to choose the best alternative.

Risk Management Procedure
Risk Identification
Risk Estimation:
Quantitative Methods
Qualitative Methods
Risk Determination:
Computation of Risk Effects &
Overlapping Effects
Risk Evaluation:
Social Costs
Risk Reduction
Risk Avoidance
Risk Coping:
Management Attitude
Adapting Culture
RiskAssessment
Inferences & Decisions
Uncontrollable
Controllable
Manage & Implement plans accurately
Reduce the intensity with good forecasting

Projects devoid of risk & uncertainty are beyond our imagination. Projects always
result in creation of comforts where change is inevitable. This change can be predicted
to some extent & some remains to be unpredictable. This unpredictability leads to
uncertainty or uncontrollable risks where the predictable future can be controlled.
The single most difference between successful projects & unsuccessful projects is
‘management of risks’, before crisis creeps in to turn the project obdurate.
This efficient & timely management of risks calls for,
 Apperception of risks as they exist;
 Understanding the sources of risk;
 Restraining the risk by use of appropriate techniques;
 Designing a structured response in terms of alternative plans, solutions &
contingencies;
 Instilling a positive attitude amongst team members by indoctrinating them to
face risky situations instead of facing surprises.
All this is attributable to some such factors as,
 Culture of the project team;
 Attitudes of the project team;
 The perceptions of the project team;
 The nature & magnitude of the project;
 The cause & effect of the project in terms of scope.

However the logical process of risk management may be as follows,
 Identification of risks or uncertainties;
 Analysis of the implications (individual & collective);
 Response to minimize risk;
 Allocation of appropriate contingencies.
As regards resources of risk, they are internal & external, predicted & unpredicted.
They jump into the arena of projects with the conception of the project and suck the
blood of a project manager till the project is commissioned successfully.
If the risk is within the manageable limits it tends to be positive & does not become a
hindrance in the performance of the project. It all depends on the management team
to judge the risk factors & tackle which is the matter of attitude.
If the management is positive in confronting with the risk factors & proceeds on the
‘gung-ho’ basis certainly it can be successful. Contrarily, if it exhibits a ‘wait & see’
attitude towards risk then the project can be run over by them.
Therefore, the attitudes of the management influence the risk management
techniques or methods.
Again everything depends on the situation of the project, some project teams are
more successful by applying a cautious approach, such as, ‘wait & see’ policies, while
others may be successful in applying a ‘go for broke’ approaches.

According to H.Mikkelsen risks can be classified in the following broad categories for
the projects,
 Risk of Goal Setting;
 Risk of Project Planning;
 Risk of Programming the Project;
 Risk of incompetent Methods & Procedures; and
 Risk of Environmental factors.
 Risk of Goal Setting - goal determination for a project is truly a risky
affair as the resources & time are not only scarce but also are
undefined. This results in setting up of either too ambitious or narrow
goals that may not match with the desires of the project sponsors. To
overcome such unrealistic goal setting process, the project team is
vigorously involved in conducting thorough market & technical
analysis of the project prospects. Screening methods are strictly
employed to leave no room for uncertainty through fluffy information
furnished & only choose those projects that are really promising.

 Risk of Project Planning – in project planning the future is picturised to
the nearest reality. It is nothing but conceptualizing the future
irrespective of how it is perceived. Therefore, planning & forecasting
depends to a great extent on the perceptions of the planner. If the
planner perceives the future either poorly or extraordinarily then
those reflections can be found in ill-conceived or mirage plans.
These situations can be overcome by adopting a more structural
approach to planning & developing robust plans that focus on the
following points,
 Timely, quick estimation & testing of sensitive areas;
 Knowledge based decisions clubbed with experience on progress; and
 In-built resistance for contingencies & spontaneous changes.

 Risk of Programming the Project – the strength or weakness of the
organization stems directly from the management’s perception of the
task. The poor or incorrect perception may allow room for the project
to be staffed so with lack of knowledge or resources and thus be
managed incorrectly. However, staff can be trained, consultants &
specialists can be hired and the organization can be structured so that
there is,
 Focus on energies & skills right through the project goal;
 Demands responsibility for achievement; and
 Functions as a committed team.

 Risk of Incompetent Methods or Procedures – often it is found that
monitoring & evaluation depends on the methods & procedures which
are employed on the task. If poorly designed procedures & ill-
conceived methods are adopted they might result in inefficiency &
improper signaling on the difficulties. To overcome such emergencies
on and off the site, standard designing & testing guidelines may be
established, quality assurance methods can be implemented &
reporting procedures may be instituted that measure both progress &
performance and provide early warning signals.

 Risk of Environmental Factors – this contains factors which can
influence the project but over which it has little or no control.
Awareness of the environment can be improved by such activities as
market research, keeping open channels of communication to clients&
customers, participating in trade associations, and so on so forth.
In a nutshell, we can say that the risks can be reduced by taking care of the
following points,
 Obtaining additional & relevant information;
 Performing additional tests or simulations;
 Allocating additional resources; and
 Improving communication & managing organizational interfaces.

Project Management- Managerial Appraisal

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Project Management- Managerial Appraisal