Net Present Value Risk Analysis
an example of using risk management to shape a project’s solution
Common-practice Project Risk Management
Brainstorm, Checklists etc. Risk Registe r Prob -Impact Matrix Actions Project ObjectivesFull Process - PRAM Guide (APM, 2004)
Multi-pass Process
Road Bridge Project
City
Town
Town
Town
1
2
Two options for the
location of a new
road bridge
Regional authority
invites tenders from
industry
Option 2 is the
higher capital cost
Conditions of the Invitation to Tender
• The contractor may bid for either Option 1, Option 2 or both options
• Selected contractor will be awarded a 20-year contract
• The contractor will bear the costs of building the bridge, but will have exclusive rights to collect tolls until the end of the 20-year period.
You are the project risk manager employed by one of the
contractors in receipt of the invitation to tender
A Useful Point about Risk Analysis
“The biggest uncertainty in a risk analysis is whether we started off analysing the right thing and in the right way”
David Vose (2008) – Risk Analysis 3rd Edition
Risk analysis should be designed to answer specific questions. The first task is to verify that the right questions have been identified.
What are the right risk questions at this stage in the road bridge project? 1. Should the company pursue this opportunity?
Should the Company Pursue this Opportunity?
Recommended approach – Net Present Value Risk Analysis
Σ
NPV =
t = 0 n
C / (1 + D)
t nCt = the net cash flow over a period of time (typically 1 year), t = the period of time during which that cash flow takes place, D = the discount rate (rate of real terms loss in the value of cash expressed as a percentage - typically per annum) and
n = the number of periods of time periods (typically years) over which NPV is calculated
Inputs to the NPV Risk Model
@RISK for Excel Net Present Value Risk Model
First cycle of the risk management process
- Risk Model demonstration
Outputs from the NPV Risk Model
Answer to Question 1: A polite no bid letter
Improved Conditions of Invitation to Tender
• National government will fund 50% of the capital costs up to a maximum of £50M
• The contractor may bid for either Option 1, Option 2 or both options
• Selected contractor will be awarded a 20-year contract
• The contractor will bear the costs of building the bridge, but will have exclusive rights to collect tolls until the end of the 20-year period.
As your risk manager, what is your advice?
1. Rerun the first pass risk model with the changed condition 2. Develop a revenue risk model Second cycle of risk
@RISK for Excel Net Present Value Risk Model
Second cycle of the risk management process
- Risk Model demonstration
Output from the Second Cycle of Risk Analysis
Risk Management Process Third Cycle - Commercial Strategy
Revenue
Sources of uncertainty
1. Future traffic trends
Future city development
Cost 2. Opening date 3. Planning consents Materials Contracting strategy Bridge design Bridge design
Influenced by
Contractor Contractor Economic conditions Regional authority Contractor Regional authority Economic growth Mutual agreement Toll chargesSummary of Important Points
• Risk Management can be used to shape the project solution
• An iterative top-down approach is required to do this
• The most important sources of uncertainty may be those associated with economic benefits rather that project delivery
• NPV risk analysis can be used to make choices between mutually exclusive options
• Understanding relevant sources of uncertainty is important
• The commercial solution should align liability for cost with influence over key sources of uncertainty
The Project Risk Maturity Model – Level 4
The risk management process leads to the selection of risk-efficient strategic choices when setting project objectives and choosing between options for project solutions or
delivery. Sources of uncertainty that could affect the achievement of project objectives are managed systematically within the
context of a team culture conducive to optimising project outcomes.