Assignment - PM0012 - Project Finance and Budgeting - Set 1

Sikkim Manipal University - MBA - PM0012 - Project Finance & Budgeting

Semester: 3 - Assignment Set: 1

Question 1: Write short notes on the following:a) Risks Related to Contractorsb) Key Risks Vs. project life cycle

Answer:

a) Risks Related to Contractors:

There are several risks that are related to contractors. If the project has unsuitable construction program planning, it might be the result of inadequate program scheduling, innovative design or contractor’s lack of information in planning construction programs. The variations in construction programs also lead to the same results. You can reduce the negative influence of the two risks by working out an informative program in the design phase, and by examining the constructability of innovative design. It is advisable to appoint a contractor or a project manager to avoid chaos in the management of construction team and programs. The lack of sufficient professionals and managers, and sufficient amount of skilled labor, results delay in the construction phase.

The contractor can conduct frequent meetings with the team and the project manager so that, he will be able to avoid difficulty in construction and the changes in design. He should also arrange a suitable time for the work, so that the workers will not be distracted because of sound insulation and construction. They should work out perfect safety measures to improve the awareness regarding safety. For example, if the contractor provides proper guidance to the employees to tackle the changing weather, it will reduce the health problems of the employees.

Managing Contractor risks:

Contractor risk-reduction programs must be easy to implement in order to be effective, particularly at small operations and job sites. The programs should be designed to be implemented by either hourly personnel or management, with minimal additional training, using predetermined forms and checklists of critical items applicable to the site and expected jobs (e.g. insurance certification, training documents, fall protection, lockout/tag out, and PPE). The effectiveness of a contractor risk-reduction program can be measured by its application and enforcement, and enviable safety record, measured on an hours worked basis, as compared to the rest of the world. The result is a massive increase in enforcement and financial risks that require aggressive risk-reduction programs, particularly those aimed at contractors and subcontractors.

A risk-reduction program for contractors and subcontractors must begin with a company policy that mandates protection for its failure can be measured by its tolerated breach, generally long before an accident ever takes place. Contractors and subcontractors must be monitored for safety and health contract compliance, just like they are for job performance. Documented enforcement of contracts, including suspension and termination, should be the means for addressing contractor and subcontractor safety and health failures. “Form” warning notices and letters, as well as management training, can make this difficult task easier for site personnel charged with implementing risk-reduction programs.

b) Key Risks Vs. project life cycle:

You can manage the risks more effectively, if they are managed from the perspective of a project life cycle. As per the frequency of occurrence, 20 key risks are allocated into different project phases. There are many risks that occur in more than one stage of the construction

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project. For example, risks such as, tight schedule appear both in the construction and in the design phase. In the former stage, it occurs because of the expectations of the client to meet the deadlines. In the design stage, it occurs where the designers are urged to document and draw as quickly as possible. If you are able to identify the risks in the early stages, it helps to minimize the negative impacts brought about by the risks. You need to take appropriate actions to cope with these risks. The way the participants manage these risks is essential for the success of the project and financing.

An investigation into the risks that are related to the preconstruction activities states that clients, designers, and government organizations must work cooperatively from the feasibility stage in order to address the potential risks in time. There are some recommendations which are suggested by the risk investigation team such as:

Awareness from the part of the client regarding the kind of product as defined in the project brief.

Client must get help from designers and contractors to produce an appropriate project schedule and have a clear idea of the expectations and the quality of the product.

Designers must conduct detailed investigation of site conditions, to meet the clients‟ requirements in a technically competent way.

Government bodies must avoid bureaucracy and create a smooth atmosphere, to facilitate the development of the project.

Though some risks in project planning and design stages occur in the post-design stage and result in changes, most risks associated with construction are more likely to root in contractors and subcontractors. In order to make the construction work on track, there must be the involvement of the experienced contractors, as early as possible. This enables to make preparations for the development of valid construction programs.

Question 2: Explain in brief all the factors which should be considered while budgeting.

Answer:

Factors in Budgeting: Budget mainly helps to obtain statistics from the actual results. An initial predefined budget plan helps to decide the business operations. The budget is given value subsequently when; it successfully pulls out the precise financial information. Detection of the problems and correcting them before they occur is not viable, unless the information gathered is correct and precise.

It is not very difficult to create a budget, but there are several factors that you need to take into your careful consideration in order to ensure budgeting success. There are certain budget bloopers and blunders that you must be aware of. It is really unfortunate to see that the reasons for budget failure are almost the same with everybody. They all make the same




mistakes. If you do not want to fail with your budget, it is very important for you to make sure that it has the following features.

Organizations must understand that, though preparing budget is not a difficult task, but at times needs a specialist to carry out financial operation.

The following must be considered while preparing budgets:

A good working knowledge of accounting fundamentals and financial basics. An accounting system, which facilitates precise extraction of data from the business

operations. Setting up specific goals and objectives to measure them against actual results. Sales budget to identify the materials, stock levels, and labour needed to produce

sales. The factors considered during sales budget calculation include:

Trends in the marketplace Market growth rate Market size for the business Price and discount structures Knowledge about customers and their feedbacks Strength of the competitors Advantages over competitors.

Purchase budget to buy raw materials and goods required in order to supply the product. It simply decides what is necessary to produce those goods. The equation can be taken as:

Purchase Requirement = Sales + (Closing Stock – Opening Stock) – Markup

Stock budget to set up the necessary stock level required to produce the expected sales. It makes sure that money is not held up in stock while it is possible to convert it into cash.

Expense budget to plan and track the expenditure. It is not related to the repayment of liabilities. They comprise fundamental things like salaries, power and light bill, and so on.

Profit budget to give an idea about how much profit is expected from the sales level. Cash flow budget to track the flow of cash( i.e. source of the income, expenditure, and

of course the total amount obtained after deducting the expenditure from the income). Capital budget to plan the future payment of expenses. It often answers the question

“Do we have enough money to do such work?” by considering a variety of hypothetical situations that may involve various accounts.

Budget period to consider the expected duration for the execution of the planned budget. Annual budget and monthly budget are the most commonly used budget period. For convenience one can budget several consecutive periods at once.

Importance of Budgeting: Lack of proper budget in a project can be like a pilot navigating in the dark without instruments. One cannot raise money from financiers for the project without having a budget. The financiers use the budget to decide if the requested amount is well-planned and reasonable. Financial goals of a business can be achieved through budgeting. Even though small businesses can be profitable without setting any budgets, there is always a probability that their business




profitability would have increased far more than what was achieved without the budget. Budgeting benefits projects that have 3-5 years of implementation cycles. Project budgeting is chosen to:

Put down incentives and standards in business. Increase the chance of success in business by estimating and predicting the future

requirements and profit positions. Outline the expenditure, which determines the cash flow. Allow the monitoring of business operations, by building a framework. Highlight and give time to prevent potential problems before they could occur or get

worse. Eliminate the lender’s recourse to the sponsors. Obtain better financial conditions where, the credit risk of the project is better than the

credit standing risk of sponsors. Reduce political risks affecting the project.

Question 3: List and describe in brief the 10 golden rules for managing risk in a project.

Answer:

Golden Rules of Project Risk Management: The benefits of risk management in projects are huge. This enables you to gain lot of money while dealing with uncertain events. If you are able to maximise the impact of project threats and seize the opportunities, it will help you to deliver your project on time. For example, if you manage the risk in an infrastructure project by analysing and identifying them in the initial stages, it will help you to prepare to face it when it comes. Rules for Managing Risks in a Project:

2Managing of risks in a project is an indispensable part of the project. That is the reason why there exist rules so that you to manage the rules effectively. These rules also help in delivering the project on time with the results the project sponsor demands. Below mentioned are the rules for managing the project. Rule 1: Make risk management part of your project:

The first rule is essential for the success of project risk management. The proper implementation of risk management helps to get the complete benefits of this approach. You will have to face lot of faulty methods in companies. Those projects which do not have a perfect risk management approach are either ignorant, or are confident that no risks will occur in their project. Professional firms make risk management part of their day to day operations, and include it in project meetings and in the training of their staff.

Rule 2: Identify risks early in your project:

The first phase in project risk management is to identify the risks that are present in your project. The sources which are used to identify the risks are people and paper. People include your team members, who bring their personal experiences and expertise




along with them. You can also talk to other experts who might have a track record of working in projects, similar to yours. You can conduct interviews and team sessions to discover the risks. Paper includes the significant number of documents that are generated by the project. The project plan, business case, resource planning, old project plans, company intranet, and websites are some of the effective options.

Rule 3: Communicate about risks:

It is advisable to include risk communication in the tasks that you perform. You can give the project risks more importance in team meetings, thus showing its importance to the team members that give them some time to discuss these risks and report new ones. Another crucial means of communication for the project are the project manager and project sponsor or principal. You must focus your communication efforts on the risks and make sure that you do not surprise the boss or the customer. You must also ensure that the sponsor makes decisions on the top risks because some of them exceed the mandate of the project manager.

Rule 4: Consider both threats and opportunities:

Modern risk approaches focus on positive risks and the project opportunities. They turn beneficial to the project and organisation by executing the project faster, better and making it more profitable. The struggle the teams face in crossing the finishing line because of overloaded work creates a kind of project dynamics where, the negative risks matter. You must make sure that there is sufficient time in dealing with the opportunities in the project.

Rule 5: Clarify ownership issues:

Once you have created a list of risks, the next step is to state the responsibility of the risk. A risk owner has to be present for each and every risk that is found. He has the responsibility to optimise the risk for the project. This enables the people to act and carry out tasks in order to decrease threats and enhance opportunities. An important negative impact of clarifying the ownership of risk effects is that, line managers start to pay attention to a project when a lot of money is at stake. The ownership problem is very important with project opportunities. It prevents fights over surprise revenues.

Rule 6: Prioritise risks:

The project managers must prioritize risks that help them to deliver good results. As some risks need to be given more time, it is better to spend your time on the risks that cause the biggest losses and gains. You have to check for showstoppers which could derail your project. .Some of the project teams consider the effects of a risk and the likelihood that it will occur. Whatever maximizing measure you use, it should be consistent and the focus must be on the bigger risks.

Rule 7: Analyse risks:

It is essential to 3understand the nature of risks before jumping into conclusions. This will help you to analyse the risks. This analysis happens at different levels. If you are performing an individual analysis, it is advisable to understand the effects of the risks. A more detailed analysis shows the order of magnitude in categories like costs, lead time




or product quality. The analysis can also be done by focusing on the events that precede a risk occurrence and the causes of risks. Another level of risk analysis is investigating the entire project. Each project manager must have the answer regarding the requirements of the total budget or the date of the deadline of the project. The detail you collect in a risk analysis will provide valuable insights in your project and necessary input to find effective responses to maximise the risks.

Rule 8: Plan and implement risk responses:

The rule 8 helps you to make an effective response plan that give more focus to the bigger wins. If you are a person who deals with threats, you will come across the avoidance, minimisation or the acceptance of risks. Avoiding risks means maximising the project returns in such a way that you do not encounter a risk anymore. This could mean changing the supplier or adopting a different technology, and terminating a project once you deal with a fatal risk. Minimising a risk means trying to prevent a risk from occurring by influencing the causes. This can also be done by decreasing the negative effects. Accepting the risk is a good choice, if the effects on the project are minimal, or the possibilities to influence it prove to be very difficult, time consuming or relatively expensive.

Rule 9: Register project risks:

This rule emphasizes the concept of bookkeeping. If you maintain a risk log, it will help you to track the progress. This is also an excellent medium of communication that enables you to inform and update the team members and stakeholders about the progress. A risk log will help you to have the basic analysis regarding causes and effects. This clarifies all issues regarding ownership. It will have risk descriptions and recording of the project risks and the effective responses will help you to keep track of the steps which you have implemented.

Rule 10: Track risks and associated tasks:

The rule 10 states that the tracking of risks is a routine schedule which is performed by the project managers. Most of them make the job very easy by integrating these risks tasks into their daily routine. These risk tasks are used in identifying and analysing risks, and for generating, selecting and implementing responses. The tracking of risks and tasks are entirely different. The former give more importance to the risks that are likely to happen and the relative importance of those risks. It is advisable to use the Japanese kaizen 4approach which states to measure the impact of the risk management efforts and implement the improvements.

Question 4: Write a short note on the following measures for reducing project budget risks:

a) Risk detection and analysis




b) Risk allocationc) Risk managementd) Risk retention

Answer:

a) Risk detection and analysis:

The feasibility study is used to detect the risk. The primary function of analysis is to find out how fine a project can continue current profitable operations, during the period of debt. Also finds out how well the project resolves all its obligations on time. This reduces the possibility of the occurrence of risk. A few risks are examined via financial models to decide the project's cash flow and hence have the capability to meet repayment schedules. Different classes of risk can be detected in a project financing using this phase.

Project risk analysis is the detection and quantification of the probabilities and collisions of events that may harm the project. The risk analysis process identifies risk in advance, and the risk management process established methods of avoiding these risks thus reducing the impacts that may occur.

Risk detection is an initial step in the risk management course. As these potential hazards occur causing problems in its kinetics there needs to be a plan for identification. To identify these concealed threats at their origin before their occurrences whether they are quantifiable or non-quantifiable is the foremost groundwork; this groundwork is the risk identification course of action. Risk detection starts with tracing risk sources as a root cause, and its source branches including internal to external and primary to secondary.

Some of the most common risk detection methods in project risk management are as follows:

Objective Oriented Risk Detection Scenario Oriented Risk Detection Taxonomy Oriented Risk Detection Regular Risk Inspection

b) Risk allocation:

Risk is one of the major concepts in today’s engineering industry. It can either make or break a company. A lot of research has been done about this subject. Because it is vital for survival in the industry companies try to keep improving their risk strategies. Because of its specific characteristics it has a unique approach towards risk allocation. Especially interesting in this concept are the aspects risk allocation and the use of incentives.

The moment risks are detected and analysed, the parties allocate them through negotiation on the basis of contractual framework. A risk is allocated to the most appropriate party, who can manage, control, and has the financial capacity to bear it. Generally, commercial risk is allocated to the private sector and political to the state.

c) Risk management:

Project risk management is the procedure of determining or evaluating risk and developing strategies to manage it, and is concerned with identifying risk and putting in place policies to eliminate or reduce these perils. In ideal risk management, a prioritization process is




followed whereby the risks with the greatest loss and the greatest probability of occurring are handled first, and risks with lower probability of occurrence and lower loss are handled in descending order. In practice the process can be very difficult, and balancing between risks with a high probability of occurrence but lower loss versus a risk with high loss but lower probability of occurrence can often be mishandled.

Intangible risk management identifies a new type of a risk that has a 100% probability of occurring but is ignored by the organization due to a lack of identification ability. For example, when deficient knowledge is applied to a situation, acknowledge risk materializes. Relationship risk appears when ineffective collaboration occurs. Process-engagement risk may be an issue when ineffective operational procedures are applied. These risks directly reduce the productivity of knowledge workers, decrease cost effectiveness, profitability, service, quality, reputation, brand value, and earnings quality. Intangible risk management allows risk management to create immediate value from the identification and reduction of risks that reduce productivity. Risk management also faces difficulties in allocating resources. This is the idea of opportunity cost. Resources spent on risk management could have been spent on more profitable activities. Again, ideal risk management minimizes spending and minimizes the negative effects of risks.

d) Risk retention:

This is agreeing on the profit or loss obtained by risking the project. This approach is applicable for projects where the insurance cost of the risk is likely more than the whole losses sustained. Great disastrous risks are retained by default as it is difficult to insure, transfer and get back the borrowed amount. Risk retention uses funds within an organisation to pay for losses it incurs.

This Involves accepting the loss, or benefit of gain, from a risk when it occurs. True self-insurance falls in this category. Risk retention is a viable strategy for small risks where the cost of insuring against the risk would be greater over time than the total losses sustained. All risks that are not avoided or transferred are retained by default. This includes risks that are so large or catastrophic that they either cannot be insured against or the premiums would be infeasible. War is an example since most property and risks are not insured against war, so the loss attributed by war is retained by the insured. Also any amounts of potential loss (risk) over the amount insured are retained risk. This may also be acceptable if the chance of a very large loss is small or if the cost to insure for greater coverage amounts is so great it would hinder the goals of the organization too much.

Question 5: Explain & compare Finance & Budget concept.

Answer:

Finance:

Finance is the science of funds management. The general areas of finance are business finance, personal finance (private finance), and public finance. Finance includes saving money and often includes lending money. The field of finance deals with the concepts of time, money, risk and how they are interrelated. It also deals with how money is spent and budgeted. One facet of finance is through individuals and business organizations, which deposit money in a bank. The




bank then lends the money out to other individuals or corporations for consumption or investment and charges interest on the loans.

Budget:

A Budget is a plan that outlines an organization's financial and operational goals. So a budget may be thought of as an action plan; planning a budget helps a business allocate resources, evaluate performance, and formulate plans. While planning a budget can occur at any time, for many businesses, planning a budget is an annual task, where the past year’s budget is reviewed and budget projections are made for the next three or even five years. The basic process of planning a budget involves listing the business's fixed and variable costs on a monthly basis and then deciding on an allocation of funds to reflect the business's goals. Businesses often use special types of budgets to assess specific areas of operation. A cash flow budget, for instance, projects your business's cash inflows and outflows over a certain period of time. Its main use is to predict your business's ability to take in more cash than it pays out.

Question 6: What is credit risk appraisal? Explain the 5C’s of credit analysis.

Answer:

Credit risk appraisal is the process by which the lender assesses the credit worthiness of the borrower. The assessment of the various risks that can impact on the repayment of loan is credit appraisal. In short, you are determining "Will I get my money back?" Depending on the purpose of loan and the quantum, the appraisal process maybe simple or elaborate. For small personal loans, credit scoring based on income, life style and existing liabilities may suffice. But for project financing, the process comprises technical, commercial, marketing, financial, managerial appraisals as also implementation schedule and ability. The "Five C's" of Credit Analysis are:

1) Capacity:To repay is the most critical of the five factors. The prospective lender will want to know exactly how you intend to repay the loan. The lender will consider the cash flow from the business, the timing of the repayment, and the probability of successful repayment of the loan. Payment history on existing credit relationships -- personal or commercial -- is considered an indicator of future payment performance. Prospective lenders also will want to know about your contingent sources of repayment.

2) Capital:

It is the money you personally have invested in the business and is an indication of how much you have at-risk should the business fail. Prospective lenders and investors will expect you to have contributed from your own assets and to have undertaken personal financial risk to establish the business before asking them to commit any funding.

3) Collateral:

Collateral or guarantees are additional forms of security you can provide the lender. Giving a lender collateral means that you pledge an asset you own, such as your home, to the lender with the agreement that it will be the repayment source in case you can't




repay the loan. A guarantee, on the other hand, is just that -- someone else signs a guarantee document promising to repay the loan if you can't. Some lenders may require such guarantee in addition to collateral as security for a loan.

4) Conditions:

It focuses on the intended purpose of the loan. Will the money be used for working capital, additional equipment, or inventory? The lender also will consider the local economic climate and conditions both within your industry and in other industries that could affect your business.

5) Character:

It is the general impression you make on the potential lender or investor. The lender will form subjective opinion as to whether or not you are sufficiently trustworthy to repay the loan or generate a return on funds invested in your company. Your educational background and experience in business and in your industry will be reviewed. The quality of your references and the background and experience levels of your employees also will be taken into consideration.


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Assignment - PM0012 - Project Finance and Budgeting - Set 1