Definition of Risk

As already observed, risk analysis should be incorporated in the capital budgeting exercise. In general, other things being equal, a firm would be well advised to accept a project which is less risky and reject those that involve more risk. This recommendation is consistent with the assumption that the management is averse to risk.

The capital budgeting decision is based on the benefits derived from the project. These benefits are measured in terms of cash flows. As shown in these cash flows are estimates. The estimation of future returns is done on the basis of various assumptions. The actual returns in terms of cash inflows depend in other words on a variety of factors such as price sales volume effectiveness of the advertising campaign competition cost of raw materials, manufacturing costs and so on. Each of these, in turn, depends-on other variables like the state of economy, the rate of inflation, and so on. The accuracy of the estimates of future returns and, therefore, the reliability of the investment decision would largely depend upon the precision with which these factors are forecast. There as strong reasons to believe that howsoever carefully the factors having a bearing on future returns emanating from the project are forecast, the actual returns will not precisely correspond to the estimate. In other words, the actual returns will vary from the estimate. This is technically referred to as risk. The term risk with reference to capital budgeting/investment decision may, therefore, be defined as the variability in the actual returns emanating from 1 project over its working life, in relation to the estimated return as forecast at the time of the initial capital budgeting decision.

The decision situations with reference to risk analysis in capital budgeting decisions can be broken up into three types: (i) uncertainty. (ii) risk and (iii) certainty. The risk situation is one in which the probabilistic or occurrence of a particular event are known. These probabilities are not known under the uncertainty situation. The difference between risk and uncertainty, therefore, lies in the less than in uncertainty. In other words in a strict mathematical sense, there is a distinction between the two:

Risk refer to  a set of unique outcomes for a given event which can he assigned probabilities, while uncertainty refers to the outcomes given event which are too unsure to he assigned probabilities.

That is, risk exist when the maker is in a position to assign probabilities to various outcome, (i.e. probational distribution is known to him). This happens when the decision maker has some of which assigns probabilities to other projects of the same type. Uncertainly exist when the decision maker has no historical data from which to develop a probability distribution, and must make intelligent guesses in order to develop a subjective probability distribution. For example, if the proposed project is completely new to the firm. the decision maker, through research and consultation with others may be able to subjectively assign probabilities to various outcomes. Throughout this chapter, however, the terms risk and uncertainty will be used interchangeably to refer to an uncertain decision making situation.

It is, then, obvious that if the future returns are certain. That is, if they could be forecast accurately there would be no risk involved in such situations. The less accurately they are forecast the more likely would be the risk involved in the investment decision. The variability of returns and hence, risk would vary with the type of project. For instance, lease-purchase capital budgeting will according to this criterion have no risk since no variability is associated with the returns. This is because the firm purchases the asset to give it on lease for a specified number of annual lease payments. The return in other words, is absolutely certain. Another example of risk free investment is the various types of government and government-guaranteed securities. Excepting these few cases, the investment decision is faced with the problem of uncertain returns, which vary widely depending on the nature and purpose of the decision. Thus. the capital budgeting decision for starting a new product will have more uncertain returns than the one involving expansion of an existing one. Further, the estimates of returns from cost-reduction type of cap budgeting will be subject to a lower degree of risk than the revenue-expanding capital budge project.

In brief risk, with reference to capital budgeting results from the variation between estimated and the actual returns. The greater the variability between the two, the more risky is project. In the discussions that follow, we will discuss the measures to quantify risk in precise terms.

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