1. Project risk management
By A.V. Vedpuriswar
Based on the work of
Ashwath Damodaran

2. Introduction Projects involve risk as cash flows are uncertain.
How do we take the risks into account and decide whether the project is worth pursuing?

3. Adjusting for risk
The most common way of adjusting for risk is to compute a value that is risk adjusted.
Risk adjustment can take the form of a higher discount rate or a reduction in expected cash flows.
We can also do a post valuation adjustment to the value obtained for an asset.
Risk adjustment can also be made by observing how the market discounts the value of assets of similar risk.

4. Discounted cash flow approach
The value of any asset is the present value of the expected cash flows on the asset.
Either we can use the same expected cash flows that a risk neutral investor would have used and adjust the risk free rate by adding a premium.
Or we can use the risk free rate as the discount rate and adjust the expected cash flows for risk, i.e., we replace uncertain cash flows by certainty equivalent cash flows.
The more popular method is the risk adjusted discount rate approach; higher discount rates to discount expected cash flows when valuing riskier assets and lower discount rates when valuing safer assets.

5. Hybrid models
For some market wide risks such as exposure to internet rates, economic growth and inflation, it is often easier to estimate the parameters for a risk-and-return model and the risk adjusted discount rate.
For other risks, it may be easier to adjust the expected cash flows.
The biggest dangers may arise when a hybrid approach is used. It is easy to double count risk in these cases.
It may make sense to categorise the risks that the project faces and be explicit about how the risk will be adjusted in the analysis.

6. Post valuation risk adjustment
Assess the risk by valuing the investment as if it has no risk.
Adjust the value for risk after the valuation.
The common practice is to capture some of the risks in the risk adjusted discount rate and deal with the other risks in the post valuation phase as discounts & premiums.
Sometimes a post valuation discount may make sense, to reflect lack of liquidity.

7. Post valuation risk adjustment
Analysts valuing companies that are subject to regulation will sometimes discount the value for uncertainty about future regulatory changes.
A discount may also be applied in the case of companies that are vulnerable to lawsuit.
Analysts may sometimes apply a control premium.
A post valuation premium may be necessary if the expected cash flows do not fully capture the potential for large pay offs in some investments.
By controlling a firm, it may be possible to create more value than the current management.

8. Scenario analysis Various steps are involved in scenario analysis:
Determine the factors around which the scenarios will be built.
Determine the number of scenarios to be analyzed for each factor.
Estimate the asset cash flows under each scenario.
Assign probabilities to each scenario.

9. Decision trees
This technique is useful when risk is not only discrete but also sequential.
Decision trees help us to consider risk in stages and devise the right response to outcomes at each stage.
The following steps are involved:
Divide analysis into risk phases
Estimate the probabilities of the outcomes in each phases
Define decision points
Compute cash flows/value at end nodes
Fold back the tree

10. Simulation
Simulations provide a way of examining the consequences of continuous risk.
Simulations allow for more flexibility in the way we deal with uncertainty.
The steps in simulation are:
Determine probabilistic variable.
Define probability distributions for these variables.
Check for correlation across variables.
Run the simulation.
When is simulation appropriate?
Running a simulation is simplest for firms that consider the same kind of projects repeatedly.
These firms can use their experience from similar projects that are already in operation to estimate expected values for new projects.

11. Real Options
The real options approach recognises that uncertainty can sometimes be a source of additional value, especially to those who are poised to take advantage of it.
When investing in risky assets, we can learn from observing what happens in the real world.
We can modify our behaviour by increasing our potential upside from the investment while reducing the possibilities downside.
But we do not take this into account while computing cash flows in traditional methods.
The expected cash flows for a risky asset, where the holder of the asset can learn from observing what happens in early periods and adapting behaviour, will be understated.
These cash flows will not capture the diminution of the downside risk from the option to abandon and the expansion of upside potential from the options to expand and delay.

12. Real Options
The decision tree approach resembles real options in some ways.
In both approaches, optimal decisions at each stage conditioned on outcomes at prior stages.
But the decision tree approach isbuilt on probabilities and allows for multiple outcomes at each branch.
In the real options approach there are typically only two outcomes at each stage and the probabilities are not specified.
In the real options approach, the discount rate will vary depending on the branch of the tree being analysed.

13. Real Options
There are potentially three real options in many investment situations:
The first is the option to delay.
The second is the option to expand.
The third is the option to abandon an investment, if it looks like a money loser, early in the process.
A firm with exclusive rights to an investment has the option of when to take that investment and to delay taking it, if necessary.
A firm may be willing to lose money on an initial investment in the hope of expanding into other investments or markets further down the road.
The real option framework allows to apply rigorous financial analysis to corporate strategic analysis and link it with value creation and maximisation.

14. Real Options
The real options approach recognises the value of maintaining flexibility in both operating and financial decisions.
The value of real options is greatest when we have exclusivity.
The danger with the real options framework is that it is often used to justify bad investments and decisions.
Not all opportunities are options and not all options have significant economic value.
By preserving the flexibility to scale up an investment in good scenarios and to scale down or abandon the investment in down scenarios, a bad investment can be turned into a good one.