Principales Cumbres Internacionales del Medio Ambiente

In this section, the project ORG will be evaluated by the traditional method, namely the DCF, the risk estimated cost and time adjustment will be added to the project budget to create the adjusted project budget. Details about using the risk platform are included.

Project Budget Estimation

Before preparing the business case, the product manager with other stakeholders approach the risk platform owner demanding information about the projects that are of similar nature as the DMZ. The platform owner makes few queries about projects of the same nature as DMZ.

Queries about the project might be the average number of issues in such projects; how much is the gap between the actual and budgeted costs in similar projects; how long does these projects actually last; what are the events or risks to be expected; frequency of these events; and what are the measures taken to solve these issues.

The information collected can be put in a table together with the expected probability and expected impact. The probability and impact give a preliminary sense of the risks priority and effect on the project, according to the risk appetite.

# Risk Event Expect- ation

Probab-

ility Effect Impact Priority

Extra Cost

Extra Time 1 Need for training 1 0,1 3 0,1 3 69183,92 4

2 Wrong market demand 5 0,9 4 0,15 20 933982,9 8 3 Change Project Owner 2 0,3 4 0,15 8 311327,6 8 4 Insufficient control time 3 0,5 3 0,1 9 345919,6 4 5 Bad Contract/ Contractor bankrupt 1 0,1 4 0,15 4 103775,9 8

Table 4.3: Risks expectations for the business case

Table 4.3 shows few rows from the risk platform, it is only a small part of the risks that were used for the calculation in this section, the whole table with the numbers used in the calculation can be found in appendix E. The expectation and effect of the risk event are estimated on a scale from 1 to 5. Each value from the scale has a corresponding probability and financial impact.

In the first row, the expectation that the event will take place on a scale from 1 to 5 is 1, the corresponding probability can be deduced from the table 4.4, for this case the probability of the event taking place is 10% as in the second column.

from 1 to 5 it is 3, this has an impact on the project costs of 1%, this value can be taken from the table 4.5.

Expectation 1 2 3 4 5 Probability 10% 30% 50% 70% 90%

Table 4.4: Risk Probability

Table 4.5 shows the risk weights, and the table 4.4 is about probability of events based on the scales suggested by the risk matrix. These values differ from one project to another, they depend on the nature of the project, size and priority, so these values are project specific and can be set by the project team.

Impact/

Class 1 2 3 4 5

Time 0-1 week 1-4 weeks 4-8 weeks 8-26 weeks >26 weeks Financial x<1% budget x<5% budget x<10% budget x<15% budget x

>20% budget

Table 4.5: Risk Appetite

To find the expected cost of this event in case it actually takes place, the values obtained are multipliedprobability×impact×projectvalue. in the first row it is 0.1×0.01×e6.92mln=

e69184. Same logic is used to find the expected time this event would need to be resolved. From table 4.5 the event will need 4 weeks at the minimum to be resolved.

The project team gathered for a meeting to discuss the project, the requirements and expected risks and all other issues related to the project, prepared a plan to resolve the issues and prepare a plan of action for the project.

Figure 4.1: Risk Matrix- Risk Response Strategy

The actions planned regarding risks are dependant on the risk responses set for these projects and the risk appetite. Figure 4.1 is the risk matrix used to classify risks and their suitable responses.

In this matrix, the colour green refers to risks with low probability and low impact, red refers to risks with high probability and impact. The risks with low probability and high impact, and risks with high probability and low impact are the yellow part of the matrix. For example risks with high probability and high impact have to be avoided, handled directly and insured against if possible. Risks with low probability and impact can be accepted with frequent control to avoid possible elevation.

# Risk Event Expect- ation

Probab-

ility Effect Impact Priority

Extra Cost

Extra Time 1 Need for training 1 0,1 1 0,01 1 6918,392 0 2 Wrong market demand 3 0,5 4 0,15 12 518879,4 8 3 Change Project owner 2 0,3 4 0,15 8 311327,6 8 4 Insufficient control time 3 0,5 3 0,1 9 345919,6 4 5 Bad contract/ Contractor Bankrupt 1 0,1 2 0,05 2 34591,96 1

Table 4.6: Risk Data

After agreeing on the planned actions, an estimation is made to the revised risks prob- ability and impact to find the risk adjusted budget. The numbers resulting from the table are summed to give an estimation of the costs that is to be created by the risksR. Note that the values in table 4.6 are lower than numbers in table 4.3. The difference is because the staff applied the risk responses relevant to each risk. Some risks were affected and the result was lower impact or lower probability, while some responses affected the extra time required to solve the risk, and some risks are not affected at all.

The events estimated for the DMZ counted to 28 risk events, see appendix E. Applying the explained method to them gave an estimated risk costs ofe2.13 million and an extra time of 56 weeks. These numbers if added to the costs of the project will change the NPV of the project to:

N P V =P V(P) +P V(I)−R

N P V =e11.18mln−e7.74mln−e2.13mln= 1.303mln

The NPV of the project is estimated to bee1.303 million if the risk adjustment was added, this is much lower than the plain NPV that estimated the NPV to bee3.434 million. The projects duration would have been two years as proposed in the business case, the risk platform suggested that the estimated risks would add an extra 56 weeks, that is an additional year and one month to the projects budgeted time.

In the next section the project will be evaluated using the real options for the sake of comparison between the evaluation approach and the management approach.

4.4

Real Options Valuation

In this section the project DMZ will be evaluated using the revised classic approach ex- plained earlier in section 2.5.5.

4.4.1 Staged investment and Binomial Tree Base Case

The traditional NPV assumes a fixed cash flow, and it does not take uncertainty into ac- count, in this section the NPV of the project will be calculated, taking into consideration the probability of non realization of payoffs, using Binomial tree. The Binomial tree in this case will capture the probabilities of success and failure without any further options. The result of the base case scenario will be used as a benchmark to find the option value.

According to the project manager phase 1 has a 0.9 probability of success and consequently the project will continue to next phase, there is also a 0.9 probability that the phase 2 will go as planned, and there is a probability 0.05 that the project will be abandoned directly after phase 4 when it proves total failure. In case of failure the purchased hardware will be used for another function, the depreciation rate will be 10% each year.

Figure 4.2: Decision Tree- Base Case

Figure 4.2 is the decision tree with no options embedded, but as explained earlier the decision tree takes into account the probability of success and failure.

Staging the project means that proceeding the project or abandoning it is a consequence of the results of the previous phase. For sake of simplicity, the investment costs and payoffs of each year will be discounted as if they all accrued at the beginning of the year, meaning both payoffs and costs of year 4 will be discounted to year 3 as if they both occurred in year 4.

To calculate the NPV of the project the beginning should be at point A in figure 4.2 After phase 3 of the project, that is the year 2016 there are two scenario’s, the first is that all goes well, and cash savings start realize during the third phase as expected, for ten years. The second scenario is that the project appears to be a failure, so there are no cash savings and it will be scrapped for the set value of 10% depreciation a year for the hardware value at the end of 2017.

To find the PV on A, the beginning should be with discounting the savings created in the following years,P is the proceedings of the project from 2018 to 2025 discounted to the end of year 2017 andP3, P4 are cash savings in the years 3 and 4.

P = P5 (1 + 0.1)+ P6 (1 + 0.1)2 +...+ P12 (1 + 0.1)8 P = e2mln (1 + 0.1)1 + e2mln (1 + 0.1)2 +...+ e2mln (1 + 0.1)8 =e10.7million

For this project there are two scenario’s, either the project is a success and it realizes the expected savings starting year three, or it could be a failure, and the management decides to proceed anyway, for in case the project might still make some savings, and if the project does not show any advancement at the end of year 4, it will be scrapped for the book value. In other words, at the end of year 4, the payoffs are either the savingsP

with probability 0.95, or the book value of the hardware, which is at this point 60% of the

hardware’s value, with probability 0.05. At the phase 4 there are also savings P4 which

are the savings created in the year 2017, in addition toI4 the costs incurred at this year.

S= 0.6×(e4.7mln+e1.57mln+e0.65mln+e0.84mln) =e4.7mln S is the salvage value of the purchased hardware.

A= 0.95×(P4+P V(P)) + 0.05×P V(S)−I4

A= 0.95×(e2mln+e10.7mln

(1 + 0.1) ) + 0.05×

e4.7mln

(1 + 0.1)−e0.9mln=e10.39mln At the third year of the project- point B-, there is a probability of 0,95 to realize thee2 million of savings and a probability 0.05 of zero benefits in case of failure.

The NPV at point C equals:

B = 0.95×P3+ 0.05×0 +N P V(A)−I3

B= 0.95×e2mln+ 0.05×0 +e10.39mln

(1 + 0.1) −e0.76mln=e10.58mln

At point C which is the second phase, the probability is 0.1 that the pilot will fail and the project will be cancelled.

The NPV at point C is the investment in this phase with no savings in addition to the proceedings of previous step.

C= 0.9×P V(B) + 0.1×(0)−I2

C = 0.9×e10.58mln

(1 + 0.1) + 0.1×(0)−e1.69mln=e6.97mln

At the first phase of the project there is a 0.9 probability the first phase of the project will be a success and it will proceed to the next phases. In case the project appears to be a failure, the purchased hardware will be shifted to other functions, thus no salvage in this phase.

D= 0.9×P V(C) + 0.1×(0)−I1

D= 0.9×e7.4mln

(1 + 0.1)+ 0.1×(0)−e4.87mln=e1.226mln

The NPV of the project using subjective probability ise 1.226 mln. The NPV valuation using DCF calculation over estimated the projects value by aboute2.2 million, this can take the project to the wrong direction, by approving a project that has a high probability of failure or low payoffs. The probability of success and failure are assessed by the project manager based on his experience. The value calculated here is the base case of scenario analysis, it will be used as a benchmark to find the value of the real options in the following sections.

4.4.2 Staged Investment and the Option To Delay

The Goals of Real Options Analysis are to Identify flexibility in investments, integrate it into strategic decision making, manage risk inherent in flexibility and increase return on capital.

To avoid the extra costs caused by the delay, the project manager demanded that there should be a Proof of Concept (PoC). PoC is a realization of a certain method or idea to demonstrate its feasibility, or a demonstration in principle with the aim of verifying that some concept or theory has practical potential (T¨ahtinen, 2017). Based on the findings of the PoC, the project manager can decide whether to proceed, or to abandon the project. Figure 4.3 shows the decision tree of the DMZ. Assuming there is a probability p = 0.7 delay in the project due to foreseen or unforeseen events, which means there is a probability (1−p) = 0.3 that the project will proceed as planned. Cash savings are discounted to the year 2018, and the start as in the previous case from the last point which is point A in figure 4.3 and rolling back to point F.

Figure 4.3: Project DMZ, Option to Delay

The cash savings discounted to the year of phase 4 is:

P =e10.7mln

The calculations for A and B in this case are similar to A and B in the base case. C and D are the same as in A and B. The project has in both cases 0.95 probability of success and realizing the expected savings, and there is a probability of 0.05 of becoming a failure and the machines are scrapped for their book value. From previous section:

S= 0.6×(e4.7mln+e1.57mln+e0.65mln+e0.84mln) =e4.7mln S is the salvage value of the purchased hardware.

A= 0.95×(P4+P V(P)) + 0.05×P V(S)−I4 A= 0.95×(e2mln+e10.7mln (1 + 0.1) ) + 0.05× e4.7mln (1 + 0.1)−e0.9mln=e10.39mln B = 0.95×P3+ 0.05×0 +N P V(A)−I3 49

B= 0.95×e2mln+ 0.05×0 +e10.39mln

(1 + 0.1) −e0.76mln=e10.58mln

A=C=e10.39mln B =D=e10.58mln

The project has 0.7 probability of being delayed for a year, this will delay the investment and the benefits for another year, and the value at point E is:

E = 0.7×P V(B) + 0.3×P V(D)−IP ilot

E= 0.7×e10.58mln

(1 + 0.1)2 + 0.3×

e10.58mln

(1 + 0.1) −e1.687mln=e7.32mln

The proceedings from B are discounted twice, that is from the year 2017 to year 2015.

F = 0.9×P V(E) + 0.1×P V(S)−IP oC

F = 0.9×e7.32mln

(1 + 0.1) + 0.1×(0)−e4.87mln=e1.121mln

Thus, embedding an option to delay in the project makes the NPV of the projecte1.121 million. Subtracting the NPV in the base case from the value of the project with the option to delay is:

ROV =e1.121mln−e1.226mln=e−104.363

In this case the option to delay creates an additional cost ofe104.36 K. Using the option to delay, delayed the expenditures, but it also delayed the realization of benefits. This project is front loaded, meaning most of the costs are incurred at the projects early phases, the delay only affected a small part of the expenditure and the benefits that are much bigger, this caused the option to create more cost in case of delay.

4.4.3 The Option to Abandon

Assume the higher management decided to execute the project in phases. First partial purchasing of the equipment to start with a PoC. The probability of success of the PoC is 0.9, and there is a 0.1 probability of failure, and the equipment will be sold for salvage value. The second phase will be by purchasing the full equipment and launching the pilot. After launching the pilot, the managers have the option to proceed in case of success, repeat the pilot or abandon for the salvage value in case of failure. Launching the pilot has a 0.7 probability of success, and 0.3 probability of failure. Eventually, in case the savings in years 3 and 4 are not achieved, the management has the option to abandon the project for salvage value. The manager estimates the probability of total failure of the project to be 0.05, this means that the management expects the project to be a success with probability 0.95, this is assuming the first phases are correctly implemented. The managers calculated the salvage value only on equipment, considering 10% depreciation for each year of the projects life, meaning the salvage value after phase 1 is 90% of the project equipment, after phase 2 it is 80%, while after phase 4 it is 60% of the total equipment value.

To find the value of the project a backward induction is conducted. First, in case of success the cash saving created by the project for the years 4 to the year 12, as calculated earlier

Figure 4.4: The Project DMZ with Option to Abandon

and discounted to 2018 ise10.67 million, which the value at point A, it is the discounted savings of the remaining 8 years. That is in case of success of the project.

In case the management decided to abandon the project, the salvage value as explained earlier. will be depreciated for 10% a year.

The value of point A, the 4th year of the project is exactly the same as in the previous case: 0.95 probability of realizing the benefits and 0.05 probability of abandoning the project and retrieve the book value of the hardwareS1

S1= 0.6×(e4.7mln+e1.57mln+e0.65mln+e0.84mln) =e4.7mln A= 0.95×(P4+P V(P)) + 0.05×P V(S1)−I4 A= 0.95×(e2mln+e10.7mln (1 + 0.1) ) + 0.05× e4.7mln (1 + 0.1)−e0.9mln=e10.39mln At the third year of the project- point B-, there is a probability of 0,95 to realize thee2 million of savings and a probability 0.05 of zero benefits in case of failure.

The NPV at point C equals:

B = 0.95×P3+ 0.05×0 +N P V(A)−I3

B= 0.95×e2mln+ 0.05×0 +e10.39mln

(1 + 0.1) −e0.76mln=e10.58mln

The NPV at point C or the pilot there is a probability of 0.7 to proceed the project, and a 0.3 probability of abandoning the project, and the salvage value is the value of the hardware depreciated at a rate of 10% a year. The salvage value at this phase is:

S2= 0.8×(e4.77mln+e1.58mln) =e5.08mln

C= 0.7×P V(B) + 0.3×(S2)−IP ilot

C = 0.7×e10.58mln

(1 + 0.1) + 0.3×(e5.08mln)−e1.69mln=e6.43mln 51

At D, there are the proceedings from the pilot phase in case of success and the salvage valueS3 in case of failure.

S3 = 0.9×e4.87mln=e4.3mln D= 0.9×P V(C) + 0.1×P V(S3)−IP oC D= 0.9×e6.93mln (1 + 0.1) + 0.1× e4.3mln (1 + 0.1)−e4.87mln=e785.287 the real option on the project with an option to abandon is:

ROV =e785.287−e1.226mln=−e440.510

The option to abandon creates a loss of e440K, this is the expected outcome for giving up the savings expected the following years when abandoning the project.