CIVE5233M/CIVE5235M Risk Management Mock Exam 2

Question 1 [34 marks]

Country X  is a  low-income country growing fast economically, despite  public admiration  being  relatively inefficient and ineffective. In particular, the judiciary is very inefficient, and both Civil and criminal sentences take on average more than ten years for the first grade.

In Country X, the government owns (80%) the Electricity Utility (Utility X), a Limited liability company.

Five years ago, Utility X decided to deploy a new power plant to satisfy the rising demand for electricity in Country X. Hence, Utility X borrowed directly from a bank to finance the new power plant. The same year, a Special Purpose Vehicle (SPV) was incorporated and completely owned and controlled by Utility X, as shown in Figure 1.

The  SPV  acts  as  a  client for the  project,  and the  prime  contractor  is  an  international  contractor  called Engineering Co. The prime contract is a reimbursable contract with a mark-up based on 10% of the total cost incurred. The Engineering Co. has wide experience in the design, construction, and management of CCGT power  stations,  but  it  has  a  controversial  reputation  has  in  some  international  projects  demonstrated opportunistic behaviours.

The Engineering Co. employed a subcontractor that is fully responsible for the construction of the project. The Subcontract  mirrors the  exact  statements  about  risk  and  liability  in  the  prime  contract  to  transfer the construction risks effectively.

The Subcontract  is  based on a fixed-price contract, and  it  is estimated that  if the  project  is on  budget, Construction Co. will have a mark-up of 10% compared to the total value of the Subcontract.

The  construction  Co.  needed  this  contract  desperately  because  it  has  extensive  debt  compared  to  its capitalisation.  The  capitalisation  of  construction  Co.  is  also  very  small  compared  to  the  value  of  the Subcontract, so construction Co. wishes to deliver the project successfully to service the previous debt and improve the financial sustainability in the future. The entirety of the debt associated with Construction Co was borrowed from Lender Co, the only bank in Country X.

Shareholder 80%

Reimbursable Contract

Fixed Price Contract

Figure 1: contracting structure for Project X

1.    Can this project be considered a project finance transaction? If so, Why?                                    [5 marks]

2.   What are the strength and weaknesses of this contractual framework in regard to risk transfer? [5 marks]

3.    Discuss the risk exposition of the Engineering Co if the prime contract is payable entirely at the             completion of the project.                  [5 marks]

4.    Discuss the risk exposition of the Engineering Co if the prime contract is payable monthly, based on the estimation of the cost incurred.                                                                 [5 marks]

5.   Which project stakeholder(s) is (are) more exposed to the construction risk and why?             [4 marks]

6.   What scenario do you envisage during the delivery of the project, and why?                      [5 marks]

7.    How can the contracting structure be improved? Please redesign the structure if necessary.  [5 marks]

Question 2 [32 marks]

Assume that you are a manager of an International Oil Company .  Assess whether the following scenarios involve real options. For each scenario, consider the following aspects explicitly:

•    Who has the option?

•    What is the cost of the option?

•    What is the strike price?

•    What type of option is it? (e.g. call, put)

•    In which conditions the real option is “in the money”?

1.    Scenario  1: You get the  concession for the  extraction  of an  oil field,  and you  pay  annually for this concession. You can decide whether to invest in building the oil well or not.                               [8 marks]

2.    Scenario 2: The national government pays you for the exploration of oil reserves in a specific territory. You are paid exclusively for the exploration service.                                                                                  [8 marks]

3.    Scenario 3: The national government pays you for the exploration of oil reserves in a specific territory. If accessible (technically and economically) reserves are found, you have a share in the revenue generated by the oil reserve, only if you co-invest in the oil well. If you decide not to invest in the well, you can either sell your concession to another international oil company or sell it to the national government at a pre- defined price.           [8 marks]

4.    Scenario 3: The national government pays you for the exploration of oil reserves in a specific territory. If accessible (technically and economically) reserves are found, you have a share in the revenue generated by the oil reserve, only if you co-invest in the oil well. If you decide not to invest in the well, you can sell your concession to another international oil company. The national government can exercise the veto on this  transaction,  i.e.  they  can  forbid  specific  international  oil  companies  to  acquire  the  extraction concession. If the national government exercise the veto, they are forced to buy your concession right at a specified price.          [8 marks]