Risk and Uncertainty in Capital Budgeting

13th October 2021 0 By indiafreenotes

The Capital budgeting is based on Cash flows. These cash flows are estimated cash flows. The estimation on future returns, cash flows, is done on the basis of various assumptions. The actual returns in terms of cash inflows depend on a variety of factors such as price, sales volume, effectiveness of advertising campaign, competition, cost of raw material, manufacturing cost and so on. Each of these, in term, depends on other variables like the state economy, the rate of inflation, govt policy and so on. Risk in the variability in the actual returns in relation to estimated return as forecast at the time of initial capital budgeting decisions.

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.

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.

Uncertainty:

The difference between risk and uncertainty, therefore, lies in the fact that variability is less in risk than in uncertainty. The risk situation is one in which the probability of occurrence of a particular event is known. These probabilities are not Known under uncertainty situation.

Risk refers to a set of unique outcomes for a given event which can be assigned probability, while uncertainty refers to the outcomes to a given event which are too unsure to be assigned probabilities. However, in practical terms, risk and uncertainty are used interchangeably.

In brief, risk with reference to capital Budgeting, results from the variation between the estimated and actual return. The greater the variability between the two, the riskier is the project.

Various evaluation methods are used for risk and uncertainty in capital budgeting are as follows:

(i) Risk-adjusted cut off rate (or method of varying discount rate)

(ii) Certainly equivalent method.

(iii) Sensitivity technique.

(iv) Probability technique

(v) Standard deviation method.

(vi) Co-efficient of variation method.

(vii) Decision tree analysis.