Home » **ANALYSIS OF RISK AND UNCERTAINTY**

ASSESSMENT OF PROJECT RISK
The major features relating to the methodology followed by the Indian corporate to assess the project risk and the relative significance assigned to different risk assessment techniques are summarized below.
• The respondent firms use, as can be expected, more than one technique out of the available techniques, namely, sensitivity analysis, scenario analysis, risk adjusted discounted

Decision-tree Approach
The Decision-tree Approach (DT) is another useful alternative for evaluating risky investment proposal. The outstanding feature of this method is that it takes into account the impact of probabilistic estimates of potential outcomes. In other words, every possible outcome is weight in probabilistic terms and then evaluated. The DT approach is especially useful for situations which decisio

Determination of Expected NPV
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Normal Probability Distribution
(v) The probability of the Index being less than 1: For the index to be 1 or less, the NPV would have may be zero or negative. Thus, the probability would be equal to 25.46 per cent as calculated in part (iii) (a) the answer.
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Normal Probability Distribution
We can make use of the normal probability distribution to further analyse the element of risk in capital budgeting. The use of the normal probability distribution is enable the decision maker to have an idea of the probability of different expected values of NPV, that is, the probability of NPV having the value of zero or less; greater than zero and within the range of two value

Independent Cash Flows Over Time
The mathematical formulation to determine the expected values of the probability distribution of NPV for any project is:
The above calculations of the standard deviation and the NPV will produce significant volume of information for evaluating the risk of the investment proposal.
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Probability Distribution Approach
In the earlier part of this chapter dealing with basic risk concepts, we had introduced the use of the concept of probability for incorporating risk in evaluating capital budgeting proposals. As already observed, the probability distribution of cash flows over time provides valuable information about the expected value of return and the dispersion of the probability distribution

EVALUATION
The certainty-equivalent approach has the merit of being simple to calculate. Another merit of this approach is that it incorporates risk by modifying the cash flows which are subjects risk. It is, therefore, conceptually superior to the time-adjusted discount rate approach.
Its weaknesses arise out of the practical problems of implementation. The crucial element application of this approach is the ce

Accept-Reject Rule
The decision-criterion here can either be the NPV method or the IRR method. Using the NPV method, the proposal would be accepted if the NPV of the certainty-equivalent cash flow is positive, otherwise it would be rejected. If the IRR method is employed, the internal rate of return (r), that equates the present value of certainty-equivalent cash inflows with the present value of the cash outflow

Present Value Calculation
After the expected cash flows have been converted into certainty equivalents, the second step under this approach is to calculate their present values. The rate of discount used for the purpose is the risk-free rate or the rate which appropriately reflects the time value of money. It is the same discount rate which is used for computing the present values in the normal course of evaluati

Comparable Riskless Flow
As already observed, the incorporation of risk in capital budgeting analysis is done, according to this approach by modifying the expected cash inflows. The first , therefore, involves the determination of the basis for modifying the cash flows to adjust for risk. The risk adjustment factor is expressed in terms of a certainty-equivalent coefficient. The certainty-equivalent coefficient r