Saturday, July 17, 2010


Risk Analysis in Capital Budgeting


In discussing the capital budgeting techniques, we have so far assumed that the proposed investment projects do not involve any risk. This assumption was made simply to facilitate the understanding of the capital budgeting techniques. In real world situation, however, the firm in general and its investment projects in particular are exposed to different of risk. What is risk? How can risk be measured and analyzed in the investment decisions?

Nature of risk

Risk exists because of the inability of the decision maker to make perfect forecasts. Forecasts cannot be made with perfection or certainty since the future events on which they depend are uncertain. An investment is not risky if, we can specify a unique sequence of cash flows for it. But whole trouble is that cash flows cannot be forecast accurately, and alternative sequences of cash flows can occur depending on the future events. Thus, risk arises in investment evaluation because we cannot anticipate the occurrence of the possible future events with certainty and consequently, cannot, make are correct prediction about the cash flow sequence. To illustrate, let us suppose that a firm is considering a proposal to commit its funds in a machine, which will help to produce a new product. The demand for this product may be very sensitive to the general economic conditions. It may be very high under favorable economic conditions and very low under unfavorable economic conditions. Thus, the investment would be profitable in the former situation and unprofitable in the later case. But, it is quite difficult to predict the future state of economic conditions, uncertainty about the cash flows associated with the investment derives
A large number of events influence forecasts. These events can be grouped in different ways. However, no particular grouping of events will be useful for all purposes. We may, for example, consider three broad categories of the events influencing the investment forecasts.

  • General economic conditions

This category includes events which influence general level of business activity. The level of business activity might be affected by such events as internal and external economic and political situations, monetary and fiscal policies, social conditions etc.

  • Industry factors

This category of events may affect all companies in an industry. For example, companies in an industry would be affected by the industrial relations in the industry, by innovations, by change in material cost etc.

  • Company factors

This category of events may affect only a company. The change in management, strike in the company, a natural disaster such as flood or fire may affect directly a particular company.

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