Risk in project-Latest -TEFS 18.10.2008 2

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    RISK IN PROJECTS

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    Risk in Projects

    Project covers projections and

    estimations based on certain

    assumptions There is always an element ofrisk and

    uncertainty involved in a project

    No project is completely free of the

    element of risk and uncertainty

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    Risk and Uncertainty in Projects

    Risk signifies the possibility of adverse

    happening

    Risk is change in project outcome that affects

    revenue /profitability /cost of project adversely

    Risks arise because of the inability of the

    decision makers to make good forecasts and

    estimates

    Agricultural Projects are exposed to variety of risks

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    Risk and Uncertainty

    According to the recent view risk ismeasurable while uncertainties notmeasurable

    Risk is defined as a situation when allpossible outcomes are known for a givenmanagement decision and probabilityassociated with each possible outcome is

    also known Risk is measured through probabilityconcepts

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    Risks that can be faced by a

    Banker May be expressed by following functional relationshipCredit risk = f [BR,FR,DR, Cr, Fr]

    BR=business risk

    FR=Financial risk

    DR=default risk

    Cr=Cost based risk

    Fr=Fiduciary risk

    It is difficult to assign a particular coefficient to each

    of the factors as the degree of risk varies from caseto case

    A banker needs to have an integrated holistic approachtowards all the risk factors while taking a creditdecision

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    Business riskBroad elements are a)Criticalinput risk b)-Operational risk c) Productionprocess risk d) Marketing and selling risk e)Labour risk

    Financial riskIt depicts whether the co. wouldbe in a position to generate sufficient profit afterpaying debt interest to finance satisfactorydividend besides ploughing back adequate

    quantum into the business. Primary indicatorsare debt equity ratio.total borrowing ratio etc

    Default riskThe risk can be determined by a)amt of cash flow b) Timing of cash flow

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    Cost base riskCan be based on the twocategory of costs a) Static and b) DynamicFormer representing those which do not bring

    positive value to the firm while the latercontributes to the growth and profitability

    Fiduciary RiskFacilities such as LC/LG arethe non fund based facilities offered by the

    banks This results in unexpected outflow offunds consequent upon invocation of bankguarantee or inability of the client to retire thebills under LC on due date

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    Types of project risks

    Financial Risk

    Not in a position to provide the expected return to

    investors of equity capital

    Business Risk Not achieving the expected earnings from the project

    Systemic risk

    System-wide or economy-wide risk

    Unsystemic risk

    Project specific risk

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    Risk in foreign projects

    In addition to normal project related risks,

    there are risks due to:

    Economic factors Foreign exchange fluctuations, taxation andinflation

    Political factors

    Govt policy in general Sudden changes in state policy in regards

    Taxation, tax incentives, availability of finances,

    repatriation of profits, wage rates, dividend rates etc

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    Sources of Risk

    Production RiskProduction practices arestandardized in industrial production Such typeof relationship does not exit in agri production.Output is subject to change due to weather,

    disease, insects ,weeds and inadequatetechnology

    Yield variations are due to many factors. Someare under control while some others are notunder the control of management

    Weather risk and technical risk are the mostimportant components of production risk

    Price trends also cause production risk

    Change in technology in a particular place may

    also have bearing on production risk

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    Price risk or Marketing risk---Production ofcrops and livestock is influenced by prices in themarket which are beyond the control of farmers

    Prices of commodity vary from year to year Financial RiskIncreases with increase amt of

    borrowed money in the farm businessUncertainty arises due to the changes in future

    interest rates and fiscal policies of RBI A careful analysis is to be made considering allthe types of risk including their sources to followthe relevant management practices

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    Measures to Manage Farm Risk

    DiversificationSelection of suitable crop and livestock enterprisesis the first step in diversification .Diversification helps to givedifferent products rather than a single product. Income variability canbe lessened through diversification

    Stable enterprise should be preferred rather than risky enterprise

    particularly in situation of farm risk InsuranceInsurance is their to reduce production risk andfinancial risk .Farm assets are insured against theft burglary fire orany other damage.Decision is judged by the following equation

    Y=F[0-r] - P where Y=Profit obtained by going for insurance

    O=opportunity cost for financial resources in terms of % ,F=financial

    reserves required r=interest earned on fin. reserves

    P=ins. premium paid by the farmer

    Agronomic practicesCrop rotations, suitable varieties ,tillage,mulching etc

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    continued

    Selecting a less risky enterpriseCrops of long gestation periodthe risk is higher--the additional risk is the risk of fall in the value ofmoney and thus fall in real value of net return

    Adoption of production methods with low variabilitySowing bylabour or by machineVarious inputs have alternatives--work can

    be performed in different ways Forward contracts and Price supportSugarmills contracting thefarmersPrice support given by Govt.-- Risk covered is less inoilseeds and pulses due to non availability of support price orfluctuation in market price

    Asset structurecapital assets in liquid form is less risky to fallback upon in case of loss .Having pair of bullock is more risky thanhaving a tractorasset structure is important to determine thedegree of risk

    Capital RationingA farmer should ration his investment amongdifferent crop and equipment

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    Statistical measures of risk

    In statistics, risk is defined as the degree ofvariability of possible outcome over time

    In projects risk is the variability or range of NetPresent Values

    NPV depends on initial outlay, net cash flowsduring the life of the project, and the discountingrate.

    Statistical measures such as probability

    distribution, expected value, standard deviation,coefficient of variation, etc are useful inestimating the risk in projects

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    Conventional Measures of Risk

    Based on experience of dealing with the projects as wellas personal understanding and the judgment of thesituation examples include

    Conservative estimate of Net Cash Flows

    Reduce net cash inflow by 10 % or increase net cashoutflow by 10 % at the time of computing the NPV ofthe project

    Project Classification

    Higher rate of discounting in case of high risk projects

    and lower rate of discounting in low risk projects ShorterPay-back Period

    Prefer shorter pay-back period in high risk projectsand longer pay-back period in low risk projects thusweeding out high risk projects

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    Continued---

    Consideration of more than one estimates

    Examine different likely situations expected such as

    pessimistic, most likely and optimistic or low risk

    condition take average as working estimate Over-all certainty index

    Used to cover element of risk in projects

    Eg: Power, Raw material and Threat from competitors

    are risks in a project-Quantify these risks individuallyand come up with an index for the project

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    Measurement of Risk in Projects

    Pay back period

    Risk adjusted rate of return

    Discounting rate = risk free rate + risk premium

    Certainty equivalent coefficient

    Ratio of certain cash flow to risky cash flows

    Risk Index

    Use of composite score of certain ratios viz. equity tototal funds ratio; trend of profit over three years etc

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    Risk Index (Tamari Horm)

    No Ratio Max. point Range

    1 Equity to total funds 25 50%

    2 Trend of profit over three

    years

    25 Loss in all 3 yrs Profit

    in all 3 yrs w/ rising trend3 Current ratio (current assets

    :current liabilities)

    20 2.00

    4 Ratio of value of production

    to total inventory(RM+WIP+FG)

    10 Lower quartile upper

    quartile

    5 Ratio of sales to tradereceivables

    10 Lower quartile upperquartile

    6 Ratio of production to

    working capital

    10 Lower quartile upper

    quartile

    Total 100

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    Sensitivity analysis

    Highlights effect of adverse variations ineach of the significant variables affectingcash flow in a project

    NPV can be assessed under the followingconditions:

    Sales volume declines

    Cost of production is increased Labour cost, Minimum wages go up

    Economic life of project reduces

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    Limitations of Risk Analysis

    Quantitative analysis of nature and extent of riskin a project has following limitations: Estimates are highly subjective the terms like high

    or low do not have the same meaning in all places,situations or persons

    Element of subjectivity in judgment overestimatecosts during performance evaluation or overestimaterevenues when there is no performance evaluation

    More reliance on data and analysis than personalexperience to avoid responsibility (ex: marketingperson relying more on market survey than personalexperience)

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    Agri Business Risk

    RISK - arises from a broad set of business

    procedures and activities which may translate to:

    Unanticipated losses ,resulting from the portfolio business

    (e.g., credit, market, liquidity)

    or

    Potential and actual losses resulting from hazard-related

    events (e.g., theft, fire, environmental impairment)

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    Risk Categories in Agriculture

    Market Risk -

    Exposure of product values to changes in industrycondition and expectations (e.g., inflation)

    Price Level Risk

    susceptibility of products values to supply-demand

    configuration,[ business cycle,] competitionand substitution.

    Customer Preference Risk

    susceptibility of products availability and design to

    particular customer needs, quality,performance expectations, class, tasteand fashions.

    Money Rate Risk

    susceptibility of interest , income and expenses ,tochanges in external rate environments

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    Contd

    Financial RiskExposure of balance sheet accounts to inherent financial optionssuch as loan repayments, early fund withdrawals, asset conversioncycles. etc.

    Liquidity Risk

    Susceptibility of an entitys funding ability to perceived changes ,in

    the entitys condition. Payment obligation assurance, Cash flow toretain, buyer-suppliers confidence ,staff payments etc

    Capital Risk

    Susceptibility of capital/investors to changes in rates [interest,exchange, ] money markets and other areas of risks.

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    Contd.

    Operational Risk

    Exposure of projects to systems failure, organizationalinefficiency and technological obsolescence

    Systems Risk

    Susceptibility of projects well-being to absence of measuring tools,

    benchmark standards, information adequacy and controls [day to day

    operations]

    Organizational Risk

    Susceptibility of projects ,to structural dysfunction, skills inadequacy,

    personnel turnovers and integrity [strike, staff leaving]

    Managerial Risk

    Susceptibility of projects to proper decisions of

    Management [recession period]

    Technology Risk

    Susceptibility of projects to obsolescence of technological hardware

    and programs ; e.g . Development in bio-tech inputs affecting

    services/product preferences.

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    Contd

    Credit Risk

    Exposure of the fund provider to possible non-collection and/or

    incurring losses due to default .

    Loan Recovery Risk

    Susceptibility of credit to the quality of project analysis and

    eligibility of borrower in terms of character and competence to

    properly handle credit and honour its terms

    Legal Risk

    Susceptibility of lenders to the effects of incomplete and/or

    unenforceable loan documents

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    RISKMANAGEMENT IN

    Agri-Business

    Risk Areas in Agri-business

    a. Marketb. Financial

    c. Operations

    d. Credite. Environment

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    High risk profile of food processing industry:

    1.Lack of flow of credit from the financial institutions

    2.Low margins

    3. High perishability

    4. Uneasy Access to seed capital and working capital

    5. Indian Products, yet to establish in International markets.

    6.As per the WTO meeting the quality standards has been a major

    hurdle to compete in the domestic and international markets.

    7.Weak data base and Market Intelligence

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    Support from Government

    To Reduce Risks and PromoteCommercialisation

    a) Exim . Policy

    b) Schemes of Ministry of Food Processing

    Industries, NHB,NHM

    c) Technology Missions - Soya, Cotton, Rubber

    d) Trade Promotion bodies - APEDA, MFPEDA

    e) Commodity Boards - Silk, Spices, Coffee,Tobacco, Tea

    f) Market development-/Regulated Markets/

    Model act / Futures Trading Exchanges

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    Risk Management- Mitigation

    Attention to effective low cost technology Formulating convincing projects for Banks -

    For credit support Follow financial discipline

    Raw material supply Own back up Ware

    house , cold storage etc.

    Contract farming arrangements Tie ups with

    farmers

    Not to rely totally on export market exploitdomestic market also

    Flexibility & adaptability approach

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    Contd

    Not to depend entirely on foreign technology,imported inputs

    Maintain continuous & quality supply

    Wherever possible take benefit of capitalinvestment subsidies, Insurance coverage etc

    Prefer industries in Agro Export Zones

    Diversify risks by proper product mix

    Make use of innovative supply chain Follow GAP, Codex norms, strict quality

    control

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    STRENGTHENING LINKAGES BETWEENPRODUCER AND CONSUMER

    EVALUATECOMMERCIAL AGRICULTUREPROJECTS ON HOLISTIC BASIS

    PERFORMANCE OF VARIOUS CRITICALFUNCTIONS TO BEALLOCATED

    AS PER ABILITY TO PROVIDEHIGHESTEFFICIENCY AT LOWEST COST

    WHERE NECESSARY CONSIDER ALLPLAYERS IN VALUECHAIN

    CREATE THECRITICAL MASS

    DEVELOP AND SYSTEMATISE SUPPLYCHAIN,LOGISTICS AMD INFRASTRUCTURE

    New Perspectives..