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Financial Management and Analysis of Projects :
7. Knowledge Management
7.11. Undertaking Sensitivity and Risk Analyses
7.11.1. Step 1: Identify the Key Variables
7.11.1.1. The selection of variables which should be tested and the detail
in which they are specified apply primarily to (i) critical cost
and benefit items, (ii) critical items likely to cause nonperformance
of financial covenants, (iii) the effect of delays; and (iv) aggregate
costs and benefits, which are the four principal areas of a project
for which sensitivity analysis normally is considered.
7.11.1.2. Critical Cost and Benefit
Items: The most effective tests are achieved by detailed disaggregation
of costs and benefits and, therefore, these items should be subjected
to specific analysis for each project. Analysis is more beneficial
if individual items that are most critical to the project are subjected
to individual review. These include on the costs side, prices of
major inputs, productivity coefficients, currency risks and inflation
rates, and on the benefits side, output prices (with the substitution
of possible tariff structure variations), rate of growth in demand
for output, and unit cost savings. While "revenues" can
be regarded as a critical benefit, it is likely to be more useful
to identify the element or elements of revenues that are most at
risk, such as "revenues from installing new sewer connections",
along with the extent/scope of their contribution to benefits and
the timing thereof.
7.11.1.3. Nonperformance of Financial
Covenants: The sensitivity of the principal elements of operations
(critical operating costs e.g., wages, power and fuel, etc.,), operating
revenues, working capital requirements, etc., that will impact on
the EA's ability to achieve (i) rate of return ratio-a
rate of return on net fixed assets in operation; (ii) self-financing
ratio; (iii) debt service coverage, etc., should be measured.
7.11.1.4. Effect of Delays:
Start-up delays, implementation delays, capacity utilization, and
full development delays, and parallel investment delays should be
subjected to analysis. Delays come in different shapes and sizes
and on different occasions (at start-up; at critical commissioning
stages, e.g., river crossings; weather delays, e.g., regular "wet
season"; resource shortages-shipping
delays, personnel strikes and slow-downs; in commissioning; in completion;
and in commencement of operation. It is important to identify the
delay(s) most likely to be considered in terms of the maximum permissible
delay(s) for inclusion as a Switching Value (SV). Delays may also
be analyzed in terms of the periodic effects on NPV (annual, forecast
percentage of completion).
7.11.1.5. Aggregate Costs and
Benefits: Sensitivity analysis of the effects of variations
in total costs and benefits of a project is useful to indicate the
collective influence of underlying variables, and should be applied
in all cases.
7.11.1.6. In addition to the foregoing,
other critical areas which merit subjection to sensitivity analysis
are potential cost overruns in project implementation and non-achievement
of capacity utilization. In simple cases the variability in the
project's rate of return on net fixed assets in operation will largely
reflect the influence of two or three variables. In such cases probability
assessments regarding those variables might provide an adequate
basis for judging the risk of the project's failure, thus avoiding
the need for more detailed quantitative risk analysis. Even in more
complex cases sensitivity analysis may some times facilitate risk
analysis by identifying the variables for which probability distributions
should be specified.
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7.11.1. Step 1: Identify the Key Variables |
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