Risk and Uncertainty Analysis | Capital Budgeting

It was assumed that those investment proposals did not involve any kind of risk, i.e., whatever the proposal is undertaken, there would not be any change in the business risk which are apprehended by the suppliers of capital. Practically, in real world situation, this seldom happens.

We know that decisions are taken on the basis of forecast which again depends on future events whose happenings cannot be anticipated/predicted with absolute cer­tainly due to some factors, e.g., economic, social, political etc. That is why question of risk and uncertainty appear before the business world although it varies from one investment proposal to another.

For example, some proposal may not even involve any risk, e.g., investment in Government bonds and securities where there is a fixed rate of return exists, some may be less risky, e.g., expansion of the existing business, others may be more risky, e.g., setting up a new operation.

That is, different investment proposals have different degrees of risk. It should be remembered that if there is any change in business risk complexion, there remains also a change in the apprehension of the creditors and the investors about the firm as well In short, if the acceptance of any proposal proves the firm more rising, creditors and investors will not be interested or will not consider it with favour which, in other words, adversely affect the total valuation of the firm.

Therefore, while evaluating investment proposals care should be taken about the effect that their acceptance may have on the firm’s business risk as apprehended by the creditors and/or investors. As such, the firm should always prefer a less risky investment proposal than a more risky one.

The riskiness of an investment proposal may be defined as the variability of its possible terms, i.e., the variability which may likely be occurred in the future returns from the project. For example, if a person invests Rs 25,000 to short-term Govern­ment securities, carrying 12% interest, he may accurately estimate his future return year after year since it is absolutely risk-free.

On the contrary, instead of investing Rs 25,000 m short-term Government security, if he wants to purchase the shares of a company, then it is not at all possible for him to estimate the future returns accurately, since the dividend rates of a company may widely vary, viz., from 0% to a very high figure.

Therefore, as there is a high degree of variability relating to future returns, it is relatively risky as compared to his investment in Government securities. Thus, the risk may be defined as the variability which may likely to accrue in future between the estimated/expected returns and actual returns. The greater is the variability between the two, the risker the project and vice-versa.

In short, risk may be defined as the degree of uncertainty about an income. Risk is a character of the investment opportunity and has nothing to do with the attitude of investors Consider the following two investment opportunities, viz., X and Y which have the possible payoffs presented in Table 7.1 below depending on the state of economy.

(Assume that the three state of economy are equally likely)

From the table 7.1 presented above, it becomes clear that the average expected return from both the projects are Rs. 1,000 (Rs 3,000 3). But the return from investment-X will lie between Rs. 990 and R 1,010 as compared to investment-Y which lies between Rs. 0 and Rs. 2,000, i.e., in other words, more uncertainty arises about the return from the investment Y.

However, decision situations may be broken down into three types: Certainty, Risk and Uncertainty.

(i) Certainly:

No Risk

(ii) Risk:

It involves situations in which the probabilities of a particular event which occurs are known, i.e., chance of future loss can be foreseen.

(iii) Uncertainty:

The probabilities of a particular event which occurs are not known i.e., the future loss cannot be foreseen. The basic difference between risk and uncertainty is that variability is less in case of risk whereas it is more in case of uncertainty although both the terms are used here interchangeably.

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