Examination Diet 2019/20 Trimester 2 COVID MODULE CODE: BSV11105 MODULE TITLE : Project Risk Management EXAMINER’S NAME: Alastair Stupart EXAM DURATION: 7 CALENDAR DAYS EXAM PAPER INFORMATION Total number of pages (including coversheet): NINE Number of Questions: SIX INSTRUCTIONS TO CANDIDATES (PLEASE READ CAREFULLY) You must answer ALL questions. An indicative word count of 1000 words per question is also set for the Exam (excluding; for example; any sketches, drawings, diagrams, formulae, or calculations). SPECIAL INSTRUCTIONS (BSV Module Codes) Please use Microsoft Word to type your answers. Where you need to produce any sketches, drawings, diagrams, formulae, or calculations to support your answers, please make sure they are inserted into the document. Please also remember to put the module number and your matriculation number at the beginning and save your work at regular intervals. You must ensure that all questions and pages are clearly numbered. When you have answered all the questions, upload the document to Moodle as one single file. Instructions on how to do this can be found in the Moodle Exam Instructions. Please ensure you do this in sufficient time and prior to the stated deadline, so as to avoid any technical issues. You should also retain a hard and soft copy of your answer script in case of queries. Please be aware that examination answer scripts may be subject to plagiarism checks. SPECIAL ITEMS INCLUDED AT THE END OF THE QUESTION PAPER: Present Value Table, Annuity Table, Standard Value Table 2 Question 1

(a)

Discuss some of the general rules for the good practice handling of risks in

business and/or construction contracts. Your answer should make specific reference to (i) lump sum (i.e. fixed price) contracts and (ii) the concept of unforeseen site

conditions.

(12 marks)

(b) A marketing agency adds a “mark-up” of 10 % on each job (this is to cover such as: risk, overheads, changes in the economy). An audit of the agency’s operations is shown in Table 1. Table 1 (i) Determine the expected profit on any given job. (5 marks) (ii) The managing director decides that recruiting additional experienced business development staff will improve the agency’s probabilities of making a profit. Having made these changes, the probabilities are as Table 2. Table 2

Percentage profit/loss

Percentage of jobs (probability)

25% profit

4

20% profit

6

15% profit

20

10% profit

30

5% profit

30

Break even

5

10% loss

5

15% loss

0

If the annual contract volume of the firm is $200m, determine the additional expenditure that the agency could spend on new staff and still make the profit that they previously achieved. (8 marks) Total [25] marks

Percentage profit/loss

Percentage of jobs (probability)

25% profit

0

20% profit

5

15% profit

15

10% profit

25

5% profit

30

Break even

10

10% loss

10

15% loss

5

3 Question 2 (a) Choose three of the reasons given in the module as to why companies should manage Health & Safety related risks. For each of the three, provide more details. (9 marks)

(b)

A project requires an immediate cash input of €4.0 million in return for the estimated cash flows (Table 3).

Table 3

State of the economy

Probability

End of year 1 (€ million)

End of year 2 (€ million)

Recession

0.2

1.0

1.5

Growth

0.3

3.0

3.5

Expanding

0.5

5.0

5.5

Assume that the state of the economy will be same in the second year as in the first. The risk-adjusted discount rate is 10%. Calculate the following: (i) The expected Net Present Value (NPV). (4 marks) (ii) The standard deviation of NPV. (4 marks) (iii) The probability of NPV being less than zero assuming a normal distribution of return. (4 marks) (iv) Interpret the figure calculated in (iii). (4 marks) Total [25] marks 4 Question 3 (a) Discuss (making reference to the Allais Paradox) why expected utility may be a true reflection of the way people decide on gambles; rather than expected monetary value. (6 marks) (b) A building contractor is providing an estimate to a potential client for carrying out a construction project. The contractor views that if they offer to undertake the work for £150k there is a 0.2 probability that the potential client will agree to the price; a 0.5 probability that a price of £100k would be agreed; and a 0.3 probability that the potential client will reject the offer. If the contractor offers to undertake the work for £100k they anticipate, there is 0.3 probability that the potential client will accept the price; a 0.6 probability that the potential client will negotiate so that a price of £80k will be agreed; and a 0.1 probability that the potential client will reject the offer. (i) Determine the price that the contractor should quote in order to maximise the expected payment that they receive from the client. (7 marks)

(ii)

Suppose that after questioning the company is able to make the following three statements:

“I am indifferent between receiving £120k for certain; or entering a lottery that will give me a 0.9 probability of winning £150k and a 0.1 probability of winning £0.” “I am indifferent between receiving £80k for certain; or entering a lottery that will give me a 0.75 probability of winning £150k and a 0.25 probability of winning £0.” “I am indifferent between receiving £100k for certain; or entering a lottery that will give me a 0.85 probability of winning £150k and a 0.15 probability of winning £0.” Given the above information: determine the price that the contractor should quote to the client – and – give reasons for your answer. (12 marks) [You may assume that U (£150k) = 1 and that U (£0) = 0] Total [25] marks 5 Question 4 Major Ventures Ltd is considering the production of a new consumer item with a five year product lifetime. In order to manufacture this item it would be necessary to build a new manufacturing facility. You have been appointed as a consultant to advise the senior management of the firm. After considering all possible alternatives, it becomes clear that management only have the following three possible strategies. (Please note that all costs are in present value terms and should not be discounted) Strategy A: Build a large facility (at an estimated cost of £6m). This strategy faces two types of market conditions (a) high demand with a probability of 0.7 or (b) low demand with a probability of 0.3. If the demand is high, the company can expect to receive an annual cash flow of £2.5m for each of the next five years. If the demand is low the cash flow would consist of a loss of £0.5m each year. (This is because of large fixed costs and inefficiencies). Strategy B; Build a small facility (at an estimated cost of £3.5m) This strategy faces the same market conditions types as Strategy A (i.e. (a) and (b)). The cash flow over the five year period for the small facility is £0.25m if the demand is low; and £1.5m if the demand is high. Strategy C: Delay building the manufacturing facility This strategy consists of leaving the decision for 12 months (while more information is collected). The resulting information can be positive or negative (with estimated probabilities of 0.8 and 0.2 respectively). At the end of the 12 months, management may decide to build either a large facility or a small facility at the same cost as at present providing the information is positive. If the resulting information is negative management would decide not to build any facility at all. Given positive information the probabilities of high and low demand change to 0.9 and 0.1 respectively (regardless of which facility is built). The annual cash flows for the remaining four-year period (for either facility type) are the same as those given for strategies A and B.

(a)

Draw a Decision Tree to represent the alternative courses of action open to

Major Ventures Ltd.

(8 marks)

(b) Determine the expected return for each possible course of action; and hence decide the best course of action for the management of Major Ventures Ltd. (10 marks)

(c)

A building firm offers a discount to Major Ventures Ltd if they agree to have a large facility constructed immediately. Determine the percentage discount

necessary to change the best course of action.

(7 marks)

Total [25] marks 6 Question 5 (a) Calculate the expected return on the five product portfolio investment of £150k (shown in Table 4) (3 marks)

Risk-return characteristics

Product

Alpha

Beta

Gamma

Delta

Epsilon

Expected return on product

20%

10%

5%

15%

3%

Proportion of investment

0.05

0.45

0.1

0.25

0.15

Table 4 (b) Sealed-bids are known to attract more bids than the English Auction approach. Why is this? (3 marks) (c) For each of these two currency risk management strategies (External hedging, Leading & lagging) discuss how it can be used to manage transactions risks. (6 marks) (d) Inflation is 5% per annum (pa) in the UK and 2% pa in the USA and it is expected to remain at these rates. Nominal interest rates are 15% pa in the UK and 5.06% pa in the USA. The spot exchange rate is $1.50/£.

(i)

Determine the real interest rate in the UK and USA. Explain whether your answers are what you would expect according to the International

Fisher relation.

(3 marks)

(ii) Determine the one year forward exchange rate. (3 marks)

(iii)

Determine what the spot rate in one year’s time will be according to the

Purchasing Power Parity Theory

(3 marks)

(ii)

Determine what the spot rate is expected to be in one year’s time according to the expectations hypothesis; giving reasons for your

answer.

(4 marks)

Total [25] marks 7 Question 6 (a) Portfolio theory aims to assist investors in creating an efficient portfolio; and diversification is a strategic device for dealing with risk. Sensible companies diversify their investments, markets, products & services. Given these statements, comment on how companies might spread the risk of declining trade and declining profitability. In your answer make reference to three of these business types: large construction company, property management firms, financial institutions, confectionary manufacturer, automobile manufacturers. (12 marks) (b) A company has five distribution centres (DC) and the predicted profit (£k) of each versus the anticipated state of the economy is given in Table 5.

Economy

Probability

DC[1]

DC[2]

DC[3]

DC[4]

DC[5]

Excellent

0.2

40

50

45

10

60

High

0.1

20

30

40

15

50

Moderate

0.4

20

25

40

20

40

Average

0.1

10

15

35

25

30

Poor

0.1

15

18

40

35

20

Recession

0.1

12

14

40

55

10

Table 5 Discuss the correlation of the DC[1] v DT[2] data, compared to the correlation of the DC[3] v DT[4] data. (5 marks) (c) Consider two financial investment packages (Double-C and Treble-B) which comprise a small portfolio, which has following risk-return characteristics and a total investment of $1 million. (Table 6)