Lecture 5 - Project Finance and Risk Management
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Transcript of Lecture 5 - Project Finance and Risk Management
Project Finance
Dr Anisur Rahman
Project Finance
Financial Vs Technical Financing projects
loans, bonds, etc.
?? Project needs finance or
funding Significant projects have some features that relate to
financing. project is very large - exceeds capacity of single organization cross national boundaries technically complex capital intensive
What is Project Finance?
Project finance is the raising of fund on a Limited Recourse basis, for the purposes of developing a large capital- intensive infrastructure project, where the repayment of the financing by the borrower will be dependent on the internally generated cashflows of the project
Project Finance
Project can be financed Privately Publicly or Hybrid
In any construction project rate of expenditure changes dramatically throughout the project lifecycle
Project Finance strategies
Characteristics of a financing strategy Enough finance Commitment The total cost of finance may be substantial
When should we start financial planning?
Funding Sources
AVAILABILITYTERMSEVALUATIONSTRUCTURINGACCEPTANCE
FINANCIAL PACKAGEto raise $ when needed andto raise $ when needed and
to minimize risk and coststo minimize risk and costs
Workable
Three Types of Finances
Equity
Debt
Aids
Equity
Funds subscribed by shareholders from their own resources.
Called Risk capital - High risk with no guarantee of return. Equity investors have the last claim if the project goes into
liquidation.
Equity sources from•Corporate Cashflow•Individual Investors•Joint ventures•Government•Multi-lateral Investors
Debt
An obligation on the borrower to repay principal and interest to pre-arranged schedule.
Commercial Banks (against security) Multilateral lenders (World Bank) Suppliers
The lender has a priority claim if the project goes into liquidation.
Aid
To meet social and community objectives:
Government to another Government tied (some obligations)
Agencies like World Bank
Non-Traditional Sources
Subordinated Debt In the case of default, creditors with subordinated
debt wouldn't get paid out until after the senior debt holders were paid in full.
Counter-trade The seller accepts goods in lieu of cash payments
Build, own, and transfer (BOT) The supplier finance, build & operate the facility to
recover the costs and profits over an agreed period of time.
Standby loan Contingent-capital mechanism under which a lender gives written
commitment to advance a specified amount of money at specified terms on demand or on a specified future date.
The loan facility will not be used unless circumstances warrant, Borrower can cancel it at anytime. Used typically
to ensure availability of critical funds following a catastrophe, or
to obtain construction financing at a lower interest rate on the assurance that permanent financing will be available when a project is complete and is generating income.
Non-Traditional Sources
Term Loan Finance large infrastructure project where very high
funding required Normally a group of financer provide the fund instead of
single financer. Cost of raising fund includes
Management fee Commitment fee Agency fee Underwriting fee Success fee Guarantee fee
Example: Channel tunnel project (UK, France) - The project cost £4.65 billion Financial structure involved 210 lending organisations – lead
financer were Japanese banks (30%), NatWest bank etc
Other Loans
Export credits Pure form of loan provided by the exporter of the
product/equipment, Bank, or Government agencies of the exporting country to promote export
Euro-currency loans Loans provided by the banks from the unregulated and informal
market for bank deposits and bank loans denominated in a currency other than that of the country where the bank is located
Debentures Similar to term loan but the loan is divided into securities and
sold through stock exchange (stock market) Usually in the form of bonds,
Financing Problems Debt Service
cash flow problems
Fees payable to banks (providers) stand-by fees
Insufficient funds miscalculation, under-estimating
Currency Inflation and exchange rate
Political and economic risks
Financial Risks
Construction finance risks must be identified earlier
Risks in a construction finance can be either within control of at least one party not within any party’s control but can be insurable not within any party’s control and can not be
insurable
Financial Risk Analysis
A typical financial risk analysis should include Financial market analysis
Cost analysisMarket analysisFinancial analysis
Inflation and Contracting
Fixed price contract most of the financial risks of the construction process
is assumed by the contractor. Clients favour this contract over others.
Cost - Plus contract based on negotiation and the owner bears most of the
financial risk. (overheads/profit as %age)
Impacts on Project Management
No project without finance. Long lead time (government bureaucracies). Lenders dictate conditions that are often tied to
production schedules. Status of borrower, location, debt/equity ratio. Therefore, understand lenders concerns
debts will be repaid on time. adequate security and recourse. for shareholders, dividends will be paid.
Decision Maker’s Preferences
Attitude toward Risk Risk averse (avoid risk) Risk neutral Risk prone (seeking)
What sort of company is yours?
Risk Analysis and Management
All projects are subject to change (risk and uncertainty).
Risks can not be removed all the time but the impact of risks can be reduced through risk management
Risk management How sources of risks in project are identified How they are assessed/measured in terms of its
likelihood, impact and consequences. How these can be dealt appropriately in a project
environment
Risk & Uncertainty Concept
Risk is when a decision is made based upon past experience or data
Known risks (material cost) Known Unknown risks (exist, but not sure about
possibility)- it could or will but don’t know when or what degree.
Unknown Unknown risks (unforeseen)
Risk Analysis & Management
IDENTIFY AVOID ACCEPT
TRANSFER SHARE ABSORB
Construction Risk Management Exercise (1)
For a demolition construction project in a very congested urban area (e.g. Southport), identify the major risks and suggest how they can be minimized.
A joint-venture construction corporation is tendering for a BOT contract from a provincial government in China Mainland for building a bridge with a 25-year concession period. The company will charge a toll for vehicles using the bridge in order to make income. The government imposes a maximum construction duration of 4 years, beyond which a damage rate will be charged per week over-run. Discuss major risks in the contract, and propose strategies of responding the risks.
Construction Risk Management Exercise (2)
Risk Management Steps
Assess Analyse MonitorManageIdentify
Risk Identification
The first and perhaps the most important step in attempting to deal with exposure to risks is to identify them.
Risk identification involves detailed examination of the project strategy, through which potential risks may be uncovered and possible responses are framed.
Risk identification focuses the attention of project management on the strategies for controlling and allocation of risk, for example through the choice of a contract strategy.
It highlights those areas where further design, development work, or clarification is needed
Should include all risks whether or not under the control of the PM, parent organisation or any stakeholder.
Sources of Risks Any factor with a probability of occurrence which
can influence the project outcome is the source of risk.
Construction risk drivers: Financial risks Legal risk Political Social Environmental Communication Geographical Geotechnical Construction Technological Demand/product risks
Examples: Internal and External risks
Internal risks External risksPoor project definitionUnreliable task estimateDecision making processAvailability of resourcesPoor tracking capabilityLack of reporting proceduresCommunication bottle neckUnchecked scope creepManagerial incompetence
Market-driven changeChanging technologyPolitical upheavalEnvironmental factorsEconomic cyclesGlobal competitionSocial changesLegislative constraint
How Do You Identify Risks?
Review current and past projects: Requires a close examination of all previous, existing projects and their potential sources of risks to reduce the impact on the project.
Project simulation: if you don’t have access to a previous project data, a project simulation will offer some assistance. It is possible to review a project schedule from a risk perspective using a number of project simulations to see different ‘what if’ scenarios across the Project.
Continue
Some of the obvious scenarios are: Can the schedule absorbs any delay? Type of risks could cause
delays? Confident of the scope? Type of risks could change scope? Available resources? Type of risks could impact on resources? What if the specifications was compromised due to poor
mgt/scope changed? What if reworking is essential? What if budget was reduced? What if client shortened the timeline? What if important approval or other significant milestones failed
to realise?
How Do You Identify Risks?
Continue
How do you identify risks? Project checklists: development of simple checklists
that are useful in recording all the potential and actual risks.
Feasibility studies: time consuming and costly but still effective.
Commercial database: Mostly secondary data; most of them already collected by some other parties for some other specific reasons. To avoid reinventing “risk” wheel.
Project team knowledge: the project team are the people who are planning and implementing. Ask them for opinions, idea and feedback by actively involve them
Interview: all the relevant stakeholders. Deliverable descriptions or product descriptions:
which defines the product in its technical details together with the information on the associated risks in dealing with the product.
Risk Assessment
Asses both the likelihood and consequences of the identified risks;
The objective is to separate the minor (acceptable) risks to major risks and to help develop a process of determining appropriate responses.
The information required will include: Likelihood of the risk; Impact of the risk; Person responsible for the risk
Probability of Risk Occurrences
An attempt to try to estimate the chances of something to happen;
When working with probability it is common to use either numerical values on an appropriate scale or use descriptive terms such as ‘high’, ‘medium’ or ‘low’.
Probability category Explanation
Score Rating1 Rare 1 in a 100 chance of occurring
2 Unlikely Slight possibility
3 Moderate Reasonable to consider it could happen
4 Likely Most probable that it could occur
5 Certain 100% chance that it could occur
Profiling the Consequence Rating
Consequence category Explanation
Score Rating
1 Insignificant Impact would be inconsequential2 Minor Noticeable but not serious impact3 Moderate Manageable scale of impact4 Major Large scale impact
5Catastrophi
cExtreme scale (possibly widespread0 of impact
Probability and Consequence MatrixProbability and Consequence Matrix
Risk Assessment Matrix
Risk event Likelihood Consequences Responsibility
Bad weather Likely
Catastrophic- substantial schedule delay Team member
Poor team skill Moderate
Major- poor quality and motivation, project drift PM
Scope changes Certain
Major- variation in time, budget and quality All Stakeholder
Budget reduction Rare
Major- downgrade of resources, quality and completion estimates PM
Risk Analysis and Evaluation
To analyse the risks and evaluating its potential impact across the project.
Each project and/or task should have a detailed analysis undertaken to investigate further the risk events likely to impact on it
Risk Analysis Techniques
A wide range of techniques is available, including: Sensitivity analysis - a quantitative technique which
allows the effect of economic changes in a project to be explored. Non-probabilistic approach
Probability analysis using Monte Carlo simulation Decision trees Utility functions Expert judgment Stakeholder meeting
Sensitivity Diagram for Major Risks in a Construction Project
Risk Response
Possible risk response strategies in project management:
Risk transfer Risk avoidance Risk control Risk acceptance
Risk Response - Transfer
Risk transfer may be accomplished either contractually by allocating risk through contract conditions or by insurance.
Parties to whom risk has been transferred generally responded by including an appropriate risk allowance in the cost estimate or charging a premium.
Abrahamson’s Principles
not be
Consideration of Risk Sharing
Contractor assuming risk The owner will be paying contingency costs that might
be more they are really worth. If the uncertain events do not occur, windfall profit. A contractor who accepts a risky fixed price contract is
at a disadvantage against a larger contractor. In the long term, the gambling contractor goes
bankrupt.
Consideration of Risk Sharing
Owner assuming risk The owner will incur additional administrative costs. the contractor must have incentive to manage and
control the cost entailed in the risk. the contractor may be in better position to negotiate
with subcontractor and suppliers. The owner must be prepared to make extra payments
as the uncertain events occur.
Risk Sharing
The owner is the initiating party of the contract
The owner is capable of loading all construction risk to the contractor
Risks over which the contractor has no control should be assumed by the owner
Risk Response
When risk cannot be transferred for whatever reason, management action is required to either reduce (or to retain) or avoid or accept it.
Risk Response: Risk avoidance
Where the level of risk is deemed unacceptable to retain, the best method of dealing with the risk is to avoid the activity with which the risk is associated.
Risk Response: Risk control
If risk cannot be fully avoided, its impact could be reduced, for example:
- by re-assessing strategy - by developing alternative solutions - by re-designing the project
Risk Response: Risk Acceptance:
Risk Acceptance: While risk avoidance and risk minimization can help to reduce the overall level of risk, some residual risk will always remain.
The decision maker needs to determine how best to control it.
The most common approach to controlling residual risk is through a contingency allowance.
Risk Response – Risk Acceptance
Contingency allowance may be expressed in the form of a single figure or as a percentage of cost, time or any other variable and added to the base estimate.
It may also be broken up into a series of smaller contingencies, which are added to the base estimate at specific time intervals.
Risk Monitoring Risk management is continuous process- Why?
Risk- is a moving target
Probability of occurrences –is a moving target
Consequence responsibility –is a moving target
Management strategies: changing nature of risk and risk sources, probability, consequences and the assignment of responsibility urge for the need to a range of monitoring and controlling strategies encompassing various degree of acceptance, mitigation and rejection
Risk monitoring describe how risks will continually be tracked to ensure that effective risk management is performed throughout the life of the project, such as use of methods and techniques like risk checklists and watch lists.
Key Points to Remember Risk is a constant companion since project involve on going changes. Every effort should be made by the relevant stakeholders to identify and
manage risk since no projects comes with crystal ball. Risk management is structured process that seeks to deliver suitable
risk management strategies for the project The scope, magnitude and impacts are dynamic – they will change
throughout the project Risk assessment is not just done at the beginning of the project – it is
performed regularly throughout the project lifecycle The management of the risk must be assigned to the authorised
stakeholders if it is to be managed effectively Attempt should be made to remove the subjectivity from both probability
and consequence estimate Do not forget to update your risk management strategies All project stakeholders should be acknowledged project risks and sign
off on the agreed control strategies at each stage of the project lifecycle Remember risks has both negative and positive impacts