Understanding Project Risk

Forecasting and projections of cash flow implicitly assume that they were known with certainty. In reality, a large number of sources of uncertainty can influence the outcome. Although the forecasts of the project financials are made with the best possible information and techniques, they are uncertain. On the other hand, a project is not risky if the project financials can be predicted with certainty. 

Risk is the chance of an undesirable outcome caused by the unpredictability of the future. The source of risk for a project is the variation or change in the values of the constituents of the project financials. For example, if the revenues change from year to year in a fashion that is different from its prediction in the project financials, then this is a source of risk. 

Some of the risks that are relevant are the business risk, the investment risk, and the financing risk. The variability in the revenues and costs of the project is the source of business risk. The change or variation in the estimate of the initial capital expenditure to build and install the project is the source of investment risk. The financing risk refers to the variation in factors that affect the financing of the project, such as changes in the interest rate. Together, the business, investment and financing risks are referred to as the financial risks of the project.

Risk is important in the assessment of a project for two reasons. Firstly, the value of the project may differ from what it was forecast to be. This type of risk represents a loss to the owner of the project. It is the stand-alone risk of the project. Secondly, the risk of the project contributes to the risk of the company and to the risk of the investors in the company. The risk of the project to an investor who has a diversified portfolio of investments is referred to as the market risk.