PROJECT RISKS

To begin with let us understand what a project is. Any proposal that will result in the use of scarce resources of a firm is a project. Thus, everything from a new product launch to shifting of the office falls within the definition of a project. Any project being considered must go through the stages of assessment, analysis and approval before it goes into the execution stage. One of the most important implications and considerations of a project proposal is its Cost to the firm.

A firm may have many sources of funds (example: Bank Loans, Promoter Funds, Cash Reserves etc.) with different rates for cost-of –capital. For simplicity sake, let us imagine a single pool of funds available to the firm at a single rate of cost-of –capital. A firm with a cost-of-capital of 10% will have to ensure it earns more than 10% and hence ensure that all the projects undertaken put together help the company in doing so.

The cost-of-capital for a project is directly linked with the degree of risk that the project carries. Projects that are riskier have to be assessed with a higher cost-of-capital than projects that are safer, i.e to assess if the risky project can earn higher returns to payback for the high cost-of-capital (which may be set much higher than 10%).

The risk in a project may come from many sources, such as the industry, government regulations, international considerations or even the project itself. The different sources of risk for a project can be:

1) Project Risk: An individual project may have higher or lower returns than expected, either because the analyst misestimated or because of project specific factors. For example, the returns from a new product launch are lower because of an un-foreseen quality issue with the product.

2) Competitive Risk: This risk emerges from the actions of the competitors that may affect the firm’s returns (favorably or unfavorably). For example, sales of the new product are lower than expected as the competitor dropped the prices of their products.

3) Industry Risk: These are factors that affect the returns of a specific industry and thus all projects considered within the industry will be exposed to this risk. Industry Risk can further be classified into three types of industry risks.

a. Technology Risk: Drastic changes in technologies compared to that while the project was analyzed can have a huge impact on the returns of the project. The sudden change in technology can immediately bring down the market prices of a product or result in a complete shift in customer preferences.

b. Legal Risk: This reflects the affect of changing laws in the operating regulatory environment. This is more prominent in the pharmaceutical industry.

c. Commodity Risk: This reflects the effects of changing prices of commodities and services that are used in a specific industry. For example, the product launch project could earn lower than expected returns due to a sudden surge in raw material prices.

4) International Risk: A project faces this kind of risk if it is international in nature and implementation is in a different country, where the cash flows (or costs) will be in a different currency. The project may also face challenges due to dynamic international relations between nations.

5) Market Risk: This source of risk affects all firms and all projects and emerges out of macroeconomic factors such as interest rates, inflation, economic growth and investor confidence etc.

Hence it is critically important that any project being considered is put through a comprehensive risk assessment exercise. This will help in arriving at a realistic assessment of returns and also in developing a contingency plan for different scenarios.

It is perhaps apt at this point to also mention that, it isn’t that pessimism, skepticism or risk aversion makes one a sound analyst. The point is to be aware of all the risks while making a project decision.

A project may be seen as a sky dive, there are obviously many risks but by knowing them well and preparing for them, we can still make a perfect landing. Higher risks often come with higher returns and hence the trick is in taking well calculated risks.