Business Risk and Simulation Modelling in Practice. Rees Michael

a net gain of $100m), and a 70 % chance of failure (creating a net loss of $10m), will have a positive (weighted) average net gain of $23m (i.e. 0.3 × 100–0.7 × 10). On a stand-alone basis, one may wish to avoid the possibility of a $10m loss; however, as part of a portfolio, the project may be acceptable:

      • As part of a mixed portfolio of stable cash-generative projects (whose cash flow could be used to cover the investment of the newer projects, or of any additional costs resulting from unexpected events), the single project may also be acceptable.

      • If the project were shared with partners, in order to reduce the effective investment and exposure to losses, one could still partly benefit from the average positive nature of the project whilst reducing the downside losses proportionally.

• A large portfolio of similar but independent projects would be profitable not only on average, but also in almost all cases. For example, given 100 such projects, it is very likely that outcomes close to the average would be observed in most cases, i.e. close to 30 successes and 70 failures. Since the benefits of success easily outweigh the cost of failure, such a portfolio would be attractive in general, as success at the portfolio level is almost guaranteed (providing that there is financing available to cover early failures). Figure 1.1 shows the distribution of the number of successful projects, such as that in 77 % of cases the number of successes is between 25 and 35 inclusive (the details of such analyses are discussed later in the text).

Figure 1.1 Number of Successful Projects out of 100, Each with Probability of Success Equal to 30%

      Risk assessment (and uncertainty analysis) can have a number of applications in the construction, adaptation and optimisation of project portfolios, to help to ensure that business growth or other objectives are met:

      • Identify, for any assumed portfolio, how likely it is that corporate objectives and targets would be achieved with that portfolio:

      • Identify whether new projects or different activities are required; this is related to the development of strategic options, which is covered separately below.

      • Understand the level of “natural diversification” within it: for example, where cash-producing projects can cover the financing of key investments, so that new calls to financing are not required at the corporate level.

      • Understand the level of residual uncertainty within the portfolio, to ensure it is appropriate and in line with risk tolerances. For example, equity investors generally expect that the business will take some level of risk, but one that is appropriate for its strategic positioning and which is in line with reasonable expectations for a business of that nature.

      • Ensure that commonalities across portfolio elements are correctly evaluated:

      • Common risks could be related to technology, exchange rates, regulatory regimes, price levels, input costs, and so on. A risk that is common to all projects or business units may be important at the corporate level but may only appear to be of medium importance at the project or business unit level.

      • In general, dependencies between the portfolio elements need to be captured correctly in order to avoid either excess or insufficient diversification of the portfolio.

      • Optimise project contingencies within a corporate context:

      • Individual project contingencies, when added up at the corporate level, could be significantly too high (or significantly too low), depending on the contingency level planned for each component (see Chapter 4).

      • The issue of balancing the amount of contingency to hold at the level of an individual item versus at an aggregate organisational level is perhaps one of the most challenging issues in practice, and has implications for organisation design (e.g. issues of centralisation and decentralisation), authorisation processes and project management.