QUESTION ONE $[40]$

Read the case study below and answer all the questions in this section.

MAKING BETTER DECISIONS ABOUT THE RISKS OF CAPITAL PROJECTS

Never is the fear factor higher for managers than when they are making strategic investment

decisions on multibillion$-$dollar capital projects. With such high stakes, we have seen many

managers prepare elaborate financial models to justify potential projects. But when it comes down to

the final decision, especially when hard choices need to be made among multiple opportunities, they

resort to less rigorous means$$arbitrarily discounting estimates of expected returns, for example, or

applying overly broad risk premiums.

There are more transparent ways to bring assessments of risk into investment decisions.

Consultants have found that some analytical tools commonly employed by oil and gas companies

can be particularly useful for players in other capital$-$intensive industries, such as those investing in

projects with long lead times or those investing in shorter$-$term projects that depend on the economic

cycle. The result can be a more informed, data$-$driven discussion on a range of possible outcomes.

Of course, even these tools are subject to assumptions that can be speculative. But the insights they

provide still produce a more structured approach to making decisions and a better dialogue about

the trade$-$offs.

Some of the tools that follow may be familiar to academics and even some practitioners. Many

companies use a subset of them in an ad hoc fashion for particularly tricky decisions. The real power

comes from using them systematically, however, leading to better decisions from a more informed

starting point: a fact$-$based depiction of how much a company$$s current performance is at risk; a

consistent assessment of each project$$s risks and returns; how those projects compare; and how

current and potential projects can be best combined into a single portfolio. Companies evaluating a

new investment project sometimes rush headlong into an assessment of risks and returns of the

project alone without fully understanding the sources and magnitude of the risks they already face.

This is not surprising, perhaps, since managers naturally feel they know their own business.

However, it does undermine their ability to understand the potential results of a new investment.

Even a first$-$class evaluation of a new project only goes so far if managers can$$t compare it with the

status quo or gauge the incremental risk impact.

Consider, for example, what happened when managers at one North American oil company were

evaluating a new investment. When they quantified the company$$s existing risk from commodity.

price uncertainty, transport congestion, and regulatory developments, they realized their

assumptions were overly optimistic about future cash flow in the new investment. In fact, in a range

of possible outcomes, there was only a $5$ percent chance that performance would meet their basecase projections. Moreover, once they mapped likely cash flows against capital requirements and

dividends, managers were alarmed that they had only a $5$ percent chance of meeting their capital

needs before the project$$s fourth year and on average wouldn$$t meet them until year six. Fortunately,

managers were able to put the insight to good use; they modified their strategic plan to make it more

resilient to risk. Managing risk $($and return$)$ in capital$-$project and portfolio decisions will always be a

challenge. But with an expanded set of tools, it is possible to focus risk$-$return decisions and enrich

decision making, launching a dialogue about how to proactively manage those risks that matter most

in a more timely fashion.

$1\mathrm{.}1.$

Provide advice to the consultants in the case study on how the project risk management

principles may be implemented prudently in order to manage their project risks effectively.

Ensure that relevant examples are mentioned to justify your theoretical assertions.

$(20)$

$1\mathrm{.}2.$

In your current studies of project risks you have familiarized yourself with various examples

of project risks. Refer to resource and team risks and provide advice to the case study

consultants on how they may ensure that these risks are managed effectively on their

projects. Apply the theory to relevant examples.

$(20)$