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Financial Management and Analysis of Projects :
7. Knowledge Management :
7.11. Undertaking Sensitivity and Risk Analyses
7.11.4. Undertaking Risk Analysis
7.11.4.1. In cases where project results are expected to be particularly sensitive
to certain variables, it has to be assessed how likely it is that
such changes would occur. This likelihood can be assessed by studying
experiences in earlier, comparable projects and by investigating
the situation in the sector as a whole.
7.11.4.2. Steps should be taken
to reduce the extent of uncertainty surrounding those variables
where possible. The following remedial actions might be taken at
the project level:
-
Development of specific agreements to ensure that contractor performance
and project quality during construction works reduces the likelihood
of delays,
-
Development of agreements for long-term supply contracts at specified
quality and prices to reduce the uncertainty of operating costs,
-
Formulation of capacity-building activities to ensure appropriate
technical and financial management,
-
Implementation of pilot phases to test technical assumptions and
to observe user's reactions, in case there is considerable uncertainty
in a large project or program, and
-
Setting of certain criteria that have to be met by subprojects
before approval. This is especially important in sector loans
where most (small) subprojects will be prepared after loan approval.
7.11.4.3.
The results of the sensitivity analysis
should be stated along with the associated mitigating actions being
recommended, and the remaining areas of uncertainty that they do
not address. Sensitivity analysis is useful at all stages of project
processing: at the design stage to incorporate appropriate changes;
at the appraisal stage to establish a basis for monitoring; and,
during project implementation to take corrective measures. The uncertainty
surrounding the results of the economic and financial analysis is
expected to decrease as the project moves into the operational phase.
7.11.4.4. For the key variables and
combinations of such variables, a statement can be presented including:
the source of variation for the key variables; the likelihood that
variation will occur; the measures that could be taken to mitigate
or reduce the likelihood of an adverse change; and the switching
values and/or sensitivity indicators.
7.11.4.5. The purpose of quantitative
risk analysis is to estimate the probability that the project FIRR
will fall below the opportunity cost of capital; or that the FNPV,
using the FIRR as the discount rate, will fall below zero. A statement
of such an estimate means that decisions can be based not just on
the single base-case FIRR but also on the probability that the project
will prove unacceptable. Projects with smaller base-case FIRRs may
involve less uncertainty and have a higher probability of being
acceptable in implementation. Projects with higher base-case FIRRs
may be less certain and involve greater risk. Risk analysis can
be applied also to projects without measurable benefits, for example
to assess the probability that unit costs will be greater than a
standard figure.
7.11.4.6. Undertaking a risk analysis
requires more information than for sensitivity analysis. It should
be applied to selected projects that are large or marginal, or where
a key variable is subject to a considerable range of uncertainty.
A large project is one that takes a high proportion of government
or the country's investment resources, for example a project using
more than 5% of the government's investment budget in the peak project
investment years. A marginal project is one where the base-case
FIRR is only marginally higher than the opportunity cost of capital.
A decision should be taken at an early stage of analysis whether
to include a risk analysis in the appraisal or not.
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7.11.3. Step 4: Analyze Key Variable Changes | Next
7.12. Model Operating Covenants |
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