Monday, November 1, 2010


Recognition of Risk in Project Evaluation

The assessment of risk is an important aspect of an investment evaluation. In theory, a number of techniques are suggested to handle risk. Some of them, such as the computer simulation technique are not only quite involved but are also expensive to use. How do companies handle risk in practice?

Companies in Asian countries consider the following as the four important contributors of investment risk
  1. Selling price
  2. Product demand
  3. Technological changes
  4. Government policies

Asian countries are fast changing from sellers’ market to buyers’ market as competition is intensifying in a large number of products; hence uncertainty of selling price and product demand are being realized as important risk factors. Uncertainty government policies, of course, are a continuous source of investment risk in developing countries in Asia.

Sensitivity analysis and conservative forecasts are two equally important and widely used methods of handling investment risk in Asian countries. Each of these techniques is used by a number of Asian companies with other methods while many other companies use either sensitivity analysis or conservative forecasts with other methods. Some companies also use shorter payback and inflated discount rates (risk-adjusted discount rates).

In USA, risk adjusted discount rate is more popular than the use of payback and sensitivity analysis. The contrasts in risk evaluation practices in Asian countries, on the other hand, and USA and UK, on the other, are sharp and significant. Given the complex nature of risk factors in developing countries, risk evaluation cannot be handling through a single number such as the net present value (NPV) calculation based on conservative forecasts or risk-adjusted discount rate. Managers must know the impact on project profitability of the full range of critical variables. An American businessmen states: “the appear to be more corporations using sensitivity analysis than surveys indicate. In some cases firms may not know that what they are undertaking is called ‘sensitivity analysis’ , and it probably is not in the sophisticated, computer oriented sense...Typically, analysts or middle level managers eliminate the alternative assumptions and solutions in order to simplify the decision making process for higher management.

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