Describe the procedure for analyzing the project risk.

Ans.  It is a well established fact that every project involves risk. Moreover, it is a practice to include a short summary of project risks in the project appraisal report. There are certain projects for which economic benefits can be quantified while for others, such quantification is not possible. Firm risk stem from technological change in production process, managerial inefficiency, availability of raw material, labour problems and changes in consumer preferences. The financial risk considers the difference between EBIT and EBT while business risk causes the

variations between revenue and EBIT. These are ways and means to reduce the project risks.

Analysis of project risks

It is the normal practice to include a short summary of project risks in each appraisal report. The purpose of this chapter is to provide a summary of project risks in order to help ensure uniformity and consistency in appraisal reports. Section-1 relates to projects for which economic benefits can be quantified and section-2 deals with projects for which such quantification is not possible.

 Projects with quantified benefits

The economic internal rate of return (EIRR) is the measure most often used to indicate the economic viability of financed projects. Calculation of the EIRR requires a set of assumptions regarding the conditions faced by the project which in the judgement of the appraisal mission are most likely to prevail during its life. However, since bank financed projects normally have a very long life, the conditions faced by the project may change for a variety of reasons. Sensitivity analysis is, therefore, carried out to determine the effects of possible changes in the values of key variables (costs, yields, and price of inputs and outputs) on the project's EIRR.The number of risks facing a project could be large, and it is neither possible nor desirable to identify all possible risks associated with a project. The risks discussed in the appraisal report should essentially be those which entail major economic consequences. These should be identified from the sensitivity analysis and described in descending order of importance with regard to their impact on the EIRR.Particular attention should be paid to risks that would substantiallyreduce the project's EIRR or render the project uneconomic by reducing its EIRR below the opportunity cost of capital. In this context, both the base-case EIRR and the sensitivity indicators are relevant. If the basecase EIRR is high, the discussion of project risks should generally include risks to which the project is highly sensitive. For example, the EIRR of most projects is highly sensitive to changes in project output, which may in turn depend on a number of factors. A discussion of the safeguards employed to minimize the risk of the outputs falling substantially below the level expected should therefore be included. For example, in an irrigation project, apart from the availability of water, output may depend on the supply of other inputs, provision of extension services, effectiveness of water management by farmer's groups, and availability of adequate infrastructure and storage facilities. Measures taken to ensure adequate and timely availability of each should be briefly explained. Risks are obviously greater in projects for which the base-case EIRR is only marginally higher than the opportunity cost of capital. These larger risks are even greater if the EIRR is highly sensitive to changes in key variables since even a small reduction in the EIRR would render the project unviable. Even when the EIRR is relatively insensitive to changes in key variables, combinations of adverse changes might easily affect the project's viability. Thus, in such cases, the remedial action proposed or adopted should be fully explained.

If the project output is traded internationally, one risk may be future changes in the price of the output, particularly if the share of a project or the country's output is small relative to the world market. In such cases, a review of world demand and supply forecasts for the good in question

should be included.By their very nature, certain types of projects such as gas and oil exploration involve very high risks. For such projects, it is necessary to supplement the sensitivity analysis with a probability analysis. The latter provides a range of possible outcomes in terms of a probability distribution and based on that project related decision could be made more intelligently. But the analysis is more complex and requires more information about events affecting the project. Due to the considerable work involved,, probability analysis of risks is usually undertaken only for project carrying a high degree of risk or for large projects where miscalculations could lead to a major loss to the economy. For such projects, the nature of the risks involved and the measures taken or recommended to minimize the risks, together with the results of the analyses, should be discussed in the appraisal report.

Projects for which benefits are not quantifiable

For projects in certain sectors or sub-sectors such as education, health, sanitation and family planning, project benefits cannot be quantified and the risks cannot be measured by sensitivity analysis. In such cases, the relationship of project risks to the project's objectives should be explained. The eventualities that might impede the realization of the objectives should be discussed in relation to the project cost and output, and also in relation to the socio-economic objectives sought by the project. In such projects, the risks are greater on the benefit side than on the cost side. For instance, in education projects, school buildings and equipment are provided to help achieve a prescribed annual output of graduates with a certain skill level. However, provision of the facilities alone may not ensure achievement of the project objectives. Their achievement may depend more upon the availability of trained teachers, provision of sufficient funds for the recurring expenditures of the institutions, curriculum and admission standards, and motivation of the students. While it is not possible to eliminate all such risks, it is essential to minimize them. Major risks of this type should be identified and

explained along with the remedial measures proposed in the section in which project risks are discussed.

The real benefits of this type of project relate to broad socio-economic goals. For education projects, these may include increased income level for the trainees and a higher level of industrial and agricultural productive. For family planning projects, the broad goals may be an

increased number of acceptors and a consequent reduction in the rate of population growth. The success of these projects depends not merely on the facilities provided, but also on the continued favourable conditions assumed by the appraisal mission. For such projects, the assumptions made regarding the relationship between the facilities provided and project's long-term objectives should be clearly explained. The conditions or facilities necessary but external to the project should also be identified, together with relevant assurances received from the government. For projects such as these, this is one of the most important aspects to be discussed in the section dealing with project risks.