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ANALYSIS OF RISK AND UNCERTAINTY

INTRODUCTION

This Chapter discusses the risk and uncertainty associated with capital budgeting. The importance of the risk dimension in capital budgeting can hardly be over-stressed. In fact, profitability and risk are closely related. It is very likely that a project which is potentially very profitable may also increase the perceived risk of the firm, This trade off between risk and profitability would have a bearing on the. investors perception of the firm before and after the acceptance of a specific proposal. If the acceptance of a proposal, for instance, makes a firm more risky the investors would not look to it with favour. This may have an adverse implication for the market price of shares, total valuation of the firm and its goal. It is therefore necessary to incorporate the risk factor in the analysis of capital budgeting. The present Chapter is concerned with methods for doing this. The effect on the risk of the firm as a whole has not been covered here, the focus is on the project risk. Section 1 of the Chapter explores the basic risk concepts. The discussion of the various methods for incorporating the risk factor into the capital budgeting decisions for an individual investment proposal is the theme of Section 2.

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