Precise Measures of Risk: Standard Deviation and Coefficient of Variation
Assigning probabilities to cash flow estimates, as a measure of variability of future returns, represents a further improvement over sensitivity analysis, which, as already mentioned was itself superior to the method which involved the estimation of future cash flows in the form of a single figure. The assignment of probabilities and the calculation of expected values, without doubt takes into account the risk in terms of variability in explicit terms in investment decisions but it suffers from a limitation to the extent that it does not provide the decision maker with a concrete value indicative of variability and therefore, of risk. In other words for a more meaningful incorporation of risk into the capital budgeting analysis, a more precise statistical measure is called for. The standard deviation (O) and the coefficient of variation (V) are two such measures which tell us about the variability associated with the expected cash flow in terms of degree of risk. Standard deviation is an absolute measure which can he applied when the projects involve the same outlay. If the projects to be compared involve different outlays the coefficient of variation is the correct choice being a relative measure.