Risk Analysis in Project Evaluation

Risk Analysis in Project Evaluation

DOI: 10.4018/978-1-5225-7696-9.ch007

Abstract

This final chapter is devoted to the analysis of the risks associated with foreign direct investments, namely business (commercial) risk, political risk, and currency exchange rate risk. Each risk factor is considered as a separate evaluation criterion. That is, an investment project may be rejected due to having a high level of any one of these three risk factors. For instance, a profitable investment proposal may not have a significant business risk but might have a high level of political risk requiring its rejection. Risk analysis is conducted only if a foreign investment project is profitable from the viewpoint of the parent company. Otherwise, there is no need for a risk analysis since a direct investment project that does not create profit for the parent company would be rejected anyway.
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The Concept Of Risk And Approaches For Identifying Risk

As it is clear from the foregoing explanations, evaluating an investment project is based on the pro forma net cash flows statement which was prepared according to the data obtained in the base year as the best estimates of the project manager. That is, the estimated net cash flows and thus the resulting profitability is a value which is expected from the investment project in the future. For instance, as it is indicated in the preceding section, the net present value of 141,538,000 EUR, which was computed according to the estimated annual net cash flows, is an anticipated value to happen in the future. However, later on, when the project is realized and starts its operation, net cash flows may change and thus the resulting net present value will change accordingly. For example, the realized NPV might be computed as 200,000,000 EUR or 250,000,000 EUR or even a loss of – 75,000,000 EUR, depending on the changes in cash flows. Why do net cash flows change? Because the future is dynamic and everything changes, nothing stays the same: sales, costs, prices, taxation laws, interest rates, exchange rates all change in the future, so do the realized NPVs.

This inevitable change is called risk in the field of finance in general and capital budgeting in specific. Thus, risk refers to the gap or discrepancy between the expected and the realized values of the investment project. The larger the gap the riskier the project would be. The existence of risk in an investment project does not only refer to a loss situation, it equally refers to a gain situation as well. That is to say, if the expected NPV of 141.5 million EUR is actually realized as 200 million EUR, this positive change is also considered a risky event, since such changes also prevent decision makers to take right decisions. Therefore, the dispersion of the end results of an investment project in either negative or positive side is generally considered risk.

Risk as a degree of change in the expected values is inevitable in all capital investment projects since those projects cover a long life span in the future. Therefore, this change or risk should be taken into account clearly and be dealt with carefully when evaluating investment projects. For this reason, in order to make more correct decisions regarding the evaluation of investment projects, the existence and, if possible, the magnitude of the risk should be identified and assessed for each investment project and then the profitability of the risky investment be analyzed in detail. Depending on the factors or variables leading to changes or creating risk, the risk related to a foreign direct investment project might be classified in three categories as business (commercial) risk, political risk, and currency risk, as elaborated in the following subsections.

Business (Commercial) Risk

The risk resulting from changes in the market values of variables, such as sales or sales revenues, all costs of production factors and capital goods, product and input prices, etc., but except those related to foreign currency and political changes, is named as business or commercial risk. Accordingly, this risk is related to the commercial activities of business firms and thus affects their economic profitability. For example, the sales estimated during the project feasibility study, later on in the operating period of project may rise by 15% and thus as a result of increses in revenues the realized profitability of the business will go up, or vice versa. Similarly, the raw material prices in the future may go up by, say, 20% or the price per unit may go down 25% and, thus, the profitability of investment would be significantly affected.

Several approaches and/or methods are used to identify or determine the business or commercial risk associated with investment projects; namely, sensitivity analysis, probability analysis, breakeven analysis, degrees of operating and financial leverages, and simulation techniques as explained in the following pages.

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