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project to fail. The risk could happen 10% of the time and when it does, the

outcome is â€“$100. What is the correct expected value? The answer is $80.

This is because the impact of the risk is to lower the result by $200 but it only

has a 10% chance of occurring. The expected value is equal to the original

$100 less $20 equals $80.28

The power of the technique is not just in the way it allows the calculation

of a correct expected value. It is in how it allows the full impact of a risk to be

assessed. This impact can then serve as a budget limit for what can be done to

mitigate the risk. In our example above the impact of the risk was calculated

to be $20. This means that it is worth spending up to $20 to make the risk go

away. This could be done either by eliminating the impact or by reducing the

probability of occurrence to zero.

Furthermore, efforts that only partially solve the potential problem can

also be easily valued. Some work which reduced the probability of occurrence

from 10% to 8% would be worth $4 (i.e. 2% of $200). Work that reduced the

impact from $200 to $160 would also be worth $4 (10% of $40). Work that did

both would not be worth $8, it would be worth just $7.20. This is because the

new impact is $160 and the probability is 8%, so the risk now has an impact of

$12.80 which is $7.20 lower than the risk prior to the mitigating actions.

Now the risks that we have been dealing with are typically thought of as

being the nasty type of risks. The technique applies equally well to upside

risks. Suppose that we thought that demand for a new product would be 100

units per day. If we design our business to sell a maximum of 100 units we

will be able to cope with the anticipated demand but not with any upside.

If we thought there was a 25% chance of demand being 120 units we might

want to build a larger production unit. We could decide whether this was

This is the same as calculating the expected value in the usual manner, which is to take 90% of 100

28

and add 10% of minus 100. It is just a slightly easier way of doing the numbers by focusing just on the

impact of the risk that is being considered and its probability.

170 The five financial building blocks

worthwhile by taking 25% of the extra profit we would make if we had the

additional capacity and comparing this with the incremental cost of building

a larger unit.

Managing risks

The usual way to look at the economic prospects of a project is to start with a

simple base case that is based on most-likely assumptions. This will produce

what I would call a â€˜first-cutâ€™ NPV. That is to say it is a rough estimate of NPV

suitable for initial screening of alternatives but not normally accurate enough

to justify a final go/no-go decision on a major project. Risk is something that

can impact on everything to do with a project. It is not therefore something

that should be handled as a specific step in the overall process of project devel-

opment. It needs to be dealt with throughout the entire stage gate process.

As work progresses with a project it is vital that the risks (both upside and

downside) be considered. There are four reasons for this:

1. To ensure that we understand the expected value NPV since it is the cor-

rect basis for taking the go/no-go decision.

2. To ensure that the project is not exposing the investor to an unacceptable

degree of downside risk.

3. To understand the nature of all the risks faced so that the appropriate

trade-off between risk and reward can be made.29

4. To ensure that the projectâ€™s value has been optimised in relation to the

risks.

We have already dealt with the first three of these. From the perspective of

economic value they are all essential. The fourth step, in my view, is optional

but strongly recommended.

I say that it is optional because, arguably, there is nothing wrong in going

ahead with a good project. It is strongly recommended because one should

always seek to go ahead with the project in the best possible way. It is for this

fourth reason of project optimisation that the risk monetisation technique is

of particular benefit. This is because it provides an easy way for allowing for

risk mitigation actions to be considered. Risk mitigation actions are things

that are done in advance of a risk in order to reduce or even eliminate the risk

altogether. We will consider an example of how the calculations are done in

the individual assignments section which follows.

The trade-off can either be done by calculating the â€˜correctâ€™ cost of capital to reflect the undiversifi-

The reflect undiversifi-

29

able risks inherent in the project or by executive judgement.

171 Building block 5: Risk

The U-shaped valley

The way that risks are gradually incorporated into our economic evaluation

can be summarised through a chart that I call â€˜the U-shaped valleyâ€™. My idea

is that the initial view of a project that we have will be based just on a single

view of the future. The individual assumptions will be most-likely values and

it will certainly be a success case. This is the right way to start our analysis

but we should never consider this to be an unbiased estimate of value. We

need to work through each risk not just so that we understand them but in

order to ensure that the project has been optimised with respect to them.

This task of risk identification and quantification will typically result in

a reduction in the calculated NPV. The risk optimisation stage should aim

to recover some of this lost value. If one is only dealing with â€˜badâ€™ risks it is

unlikely that the mitigation activities will be sufficient to return the outcome

to where the original â€˜un-riskedâ€™ NPV had been. If, however, additional ways

can be identified which serve to increase the benefit from upside risks it is

quite possible for the risk mitigation exercise to increase the value of a project

to above its original first cut estimate.

This chart depicts how this approach might work.30

NPV

Optimised

First-Cut NPV

NPV

C

A

B

â€˜Correctâ€™

Expected Value

NPV

Risk Risk

First-Cut

Identification Optimisation

Fig. 5.9 The U-shaped valley of risk

From the perspective of the first-cut NPV it may well appear that the initial

work on identifying risks has served to reduce the overall project NPV. On

Readers will probably have to have seen a glaciated valley before they really understand why I use the

30

term â€˜U-shaped valleyâ€™. The sides are almost vertical and the floor is flat.

172 The five financial building blocks

the chart the apparent value loss is shown as the distance A. In my view this

is not a value loss. This value was never there, it was simply that until the risk

identification stage the effect had not been quantified. The level titled â€˜cor-

rectâ€™ expected value NPV should serve as the point from which the value of

risk mitigation should be measured.

The fully optimised project may recover some of the apparent value loss

(i.e. the line of small squares on the chart and distance B) and may even push

value above the first-cut level (the line of small circles and the distance C).

The value associated with risk optimisation is the distance B or C.

The importance of the U-shaped valley concept is felt in two ways. First

there is the calculation of the â€˜correctâ€™ NPV after allowing for all risks. The

NPV which should be used in assessing whether or not a project creates

value for shareholders is the expected value NPV which can only be prop-

erly assessed after all risks are considered. Second, the U-shaped valley con-

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