Risk Management

RISK MANAGEMENT

Assignment 2

INTRODUCTION

This report aims to present a deterministic quantitative risk analyses for two options considered for the procurement of a real estate development project. The first option considered within the construction contract is to hire the contractor on a “Lump Sum or Fixed Price” basis while the second option is slight variation of the first option having a “liquidated damages” clause. We will explain the details of these two options later in the report. The first option is considered as the base case as it is the most common type of construction contract. We have projected the cash flows under this option and computed the various financial indicators including IRR and NPV. Thereafter, we performed a sensitivity analysis analyzing the various risks that would materialize either during the construction period or in the operation period.

We have also performed a Decision Tree Analysis (DTA) and have presented the results providing a recommendation for the Board of Directors to decide on which option the company should pursue with the project. Both the DTA and the Sensitivity Analysis complement each other and give us greater insight into the risks of the project. While all risks cannot be treated, our goal was to highlight and minimize the treatable risks in the project.

ASSUMPTIONS

The development process involved buying an undeveloped land, permitting, construction, lease up, and stabilization. Each phase in the development process has a distinct level of risk. Therefore, to be consistent, cash flows from each phase should be discounted with its own risk adjusted discounted rate. However, for sake of simplicity, we will assume a single discount rate throughout the construction and operation phase.

Consider a development project for a land valued at AED 1,000,000. In addition to the land value, there is a permitting related costs of AED 100,000 incurred at time zero. The construction is estimated to cost AED...