Risk and uncertainty are quite inherent in capital budgeting decisions.
of Risk and Uncertainty
Risk and uncertainty are quite
inherent in capital budgeting decisions. Future is uncertain and involves risk.
Risk involves situations in which the probabilities of an event occurring are
known and these probabilities are objectively determinable. Uncertainty is a
subjective phenomenon. In such situation, no observation can be drawn from
frequency distribution. The risk associated with a project may be defined as
the variability that is likely to occur in the future returns from the project.
A wide range of factors give rise to risk and uncertainty in capital
investment, viz. competition, technological development, changes in consumer
preferences, economic factors, both general and those peculiar to the
investment, political factors etc. Inflation and deflation are bound to affect
the investment decision in future period rendering the deeper of uncertainty
more severe and enhancing the scope of risk. Technological developments are
other factors that enhance the degree of risk and uncertainty by rendering the
plants or equipments obsolete and the product out of date. It is worth noting
that distinction between risk and uncertainty is of academic interest only.
Practically no generally accepted methods could so far be evolved to deal with
situation of uncertainty while there are innumerable techniques to deal with
risk. In view of this, the terms risk and uncertainty are used exchangeable in
the discussion of capital budgeting.
The capital budgeting decision is
based upon the benefits derived from the project. These benefits are measured
in terms of cash flows. These cash flows are estimates. The estimation of
future returns is done on the basis of various assumptions. The actual return
in terms of cash inflows depends on a variety of factors
such as price, sales volume, effectiveness of the advertising campaign,
competition, cost of raw materials, etc. 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. In
reality, the actual returns will vary from the estimate. This is referred to
risk. The term ‘risk’ with reference to investment decisions may be defined as
the variability in the actual returns emanating from a project in future over
its working life in relation to the estimated return as forecast at the time of
the initial capital budgeting decision.
to Luce R.D and H. Raiffa in their book, ‘Games and Decision’ (1957), the
decision situations with reference to risk analysis in capital budgeting
decisions can be broken into three types.
2. Risk and
The risk situation is one in which the probabilities of a particular event occurring are known. The difference between risk and uncertainty lies in the fact that the variability is less in risk than in the uncertainty.
In the words of Osteryang, J.S. ‘Capital budgeting’ risk refers to the set of unique outcomes for a given event which can be assigned probabilities while uncertainty refers to the outcomes of a given event which are too sure to be assigned probabilities.
Tags : Financial Management - Capital Budgeting – A Conceptual Framework
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