Net Present Value Risk Analysis
an example of using risk management to shape a project’s solution
Martin Hopkinson
Net Present Value Risk Analysis
CI05 M01 I02 Slide No. 1
Common-practice Project Risk Management
Single Pass Process
Project Objectives
Brainstorm,
Checklists etc.
Prob Impact
Matrix
Risk
Registe
r
Actions
Net Present Value Risk Analysis
Slide No. 2
Full Process - PRAM Guide (APM, 2004)
Multi-pass Process
Net Present Value Risk Analysis
Slide No. 3
Road Bridge Project
Two options for the
location of a new
road bridge
Town
Town
Option 2 is the
higher capital cost
2
1
City
Town
Regional authority
invites tenders from
industry
Net Present Value Risk Analysis
Slide No. 4
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?
Net Present Value Risk Analysis
Slide No. 5
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?
Net Present Value Risk Analysis
Slide No. 6
Should the Company Pursue this Opportunity?
Recommended approach – Net Present Value Risk Analysis
n
NPV =
ΣC
n
t
/ (1 + D)
t=0
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
Net Present Value Risk Analysis
Slide No. 7
Inputs to the NPV Risk Model
c/a = Contract award date
Net Present Value Risk Analysis
Slide No. 8
@RISK for Excel Net Present Value Risk Model
First cycle of the risk management process
- Risk Model demonstration
Net Present Value Risk Analysis
Slide No. 9
Outputs from the NPV Risk Model
Answer to Question 1:
A polite no bid letter
Net Present Value Risk Analysis
Slide No. 10
Outputs from the NPV Risk Model
Net Present Value Risk Analysis
Slide No. 11
A Graphical Representation of the NPV Risk Model
Net Present Value Risk Analysis
Slide No. 12
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 2
Second cycle of risk
management process
Net Present Value Risk Analysis
Slide No. 13
Output from the Rerun First Pass Risk Model
Net Present Value Risk Analysis
Slide No. 14
@RISK for Excel Net Present Value Risk Model
Second cycle of the risk management process
- Risk Model demonstration
Net Present Value Risk Analysis
Slide No. 15
Output from the Second Cycle of Risk Analysis
Option 2 is the better choice
Net Present Value Risk Analysis
Slide No. 16
Risk Management Process Third Cycle - Commercial Strategy
Sources of uncertainty
1.
2.
3.
Revenue
Cost
Opening date
Influenced by
Future traffic trends
Economic growth
Future city development
Regional authority
Bridge design
Contractor
Toll charges
Mutual agreement
Bridge design
Contractor
Contracting strategy
Contractor
Materials
Economic conditions
Planning consents
Regional authority
Construction time
Contractor
Net Present Value Risk Analysis
Slide No. 17
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
Net Present Value Risk Analysis
Slide No. 18
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.
Net Present Value Risk Analysis
Slide No. 19