CI05 M01 I02 Slide No. 1Net Present Value Risk Analysis

Net Present Value Risk Analysisan example of using risk management to shape a project’s solution

Martin Hopkinson

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Common-practice Project Risk Management

Brainstorm, Checklists etc.

Risk Register

Prob -Impact Matrix

Actions

Project Objectives

Single Pass Process

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Full Process - PRAM Guide (APM, 2004)

Multi-pass Process

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Road Bridge Project

City

TownTown

Town

12

Two options for the location of a new road bridge

Regional authority invites tenders from industry

Option 2 is the higher capital cost

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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

What is your advice?

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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?

2. If so, what are the most important sources of uncertainty to manage?

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Should the Company Pursue this Opportunity?

Recommended approach – Net Present Value Risk Analysis

ΣNPV =t = 0

n

C / (1 + D)t

n

Ct = 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

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Inputs to the NPV Risk Model

c/a = Contract award date

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@RISK for Excel Net Present Value Risk Model

First cycle of the risk management process - Risk Model demonstration

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Outputs from the NPV Risk Model

Answer to Question 1: A polite no bid letter

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Outputs from the NPV Risk Model

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A Graphical Representation of the NPV Risk Model

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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

3. Compare Options 1 and 2Second cycle of risk management process

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Output from the Rerun First Pass Risk Model

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@RISK for Excel Net Present Value Risk Model

Second cycle of the risk management process - Risk Model demonstration

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Output from the Second Cycle of Risk Analysis

Option 2 is the better choice

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Risk Management Process Third Cycle - Commercial Strategy

Revenue

Sources of uncertainty1. Future traffic trends

Future city development

Cost 2.

Opening date 3. Planning consentsConstruction time

Materials

Contracting strategy

Bridge design

Bridge design

Influenced by

Contractor

Contractor

Economic conditions

Regional authority

Contractor

Contractor

Regional authority

Economic growth

Mutual agreementToll charges

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Summary 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

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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.