Risk Analysis

Risk Assessment Process and Analysis

There is, of course, no return without risk. There is a tendency in investment project modelling to believe that the cash flows from investment models are somehow “real”. The inputs for the model may or may not occur, and, at best, are a considered estimate of what might happen two or more years into a project time span.

Since finance theory teaches that rational people are risk averse, then the next stage of the exercise should be to include in the model techniques for estimating the risk and uncertainty. The model should be tested to see how likely the organisation is to achieve the desired net present value. The upsides may not be a problem, but management needs to assess the possibility of lower than anticipated returns. Again, following theory, if the project earns a lower rate than the cost of capital, then the shareholder value in the company diminishes.

Two types of risk can be identified:

·       Project risk. Which is the variability of the project return.

·   Corporate risk. Since management need to invest in a mixture of projects, which have varying degrees of risk and potential return.

Risk could also be split into two categories:

·       Risk. Which can be described and quantified using some of the techniques in this lesson.

·       Uncertainty. Which can be described as random events.

Sources of risk and uncertainty could include one or more of the following:

·       Commercial and administration.

·       Competitive responses leading to reduced demand.

·       Market shifts, especially with new technology.

·       Financial – liquidity, profitability, and financial structures.

·       Knowledge and information dissemination.

·       Legal issues.

·       Currency issues, both on the supply and sales sides.

·       Partners, suppliers and subcontractors.

·       Political events in home and overseas markets (for instance, Brexit, President Trump impeachment, and so on).

·       Health emergencies (for instance, Covid-19, Ebola, HIV/AIDS).

·       Economic cycles and the effect on demand and prices.

·       Quality issues leading to reduced sales.

·       Resource availability leading to lower production.

·       Technical ability of company.

·       Innovation, copyright and the availability of new technologies.

·       Management competence and drive.

Project risk is related to corporate risk since the latter will change if management invests in risky projects.