Risk Analysis in Capital Budgeting

By: Vikram.G.BLecturer, P.G dept. of

CommerceV.D.C, Bangalore-55

Risk & uncertainty:-• Uncertainty is a situation where a decision

can lead to more than one possible outcome.

• Risk exists because of the inability of the decision maker to make perfect forecast.

• Traditional difference between Risk & Uncertainty is ▫ uncertainty can't be quantified whilst risk can.

•Risk is concerned with the use of quantification of the likelihood of future outcomes.

•Uncertainty is to cover all future outcomes which cannot be predicted with accuracy.

Why Risk Arises in Investment Evaluation?

•Because unable to anticipate occurrence of the possible future events with certainty and consequently.

•Unable to make correct prediction about the cash flow sequence.

Categories of Risk:- Risk

Unsystematic Risk

Business Risk

Internal

External

Financial Risk

Systematic Risk

Market Risk

Interest Risk

Inflation Risk

Systematic Risk:-

•It relates to economic trend whichs affect the whole market.

•It is a that portion of variation in return caused by the factors that affect the prices of all securities and it can’t be avoided.

•The effect in a systematic return causes the prices of all individual shares/bonds to move in the same direction.

Reasons for occurring of Systematic Risk

•Market Risk: Variations in price sparked off due to real social, political and economic events.

•Interest Rate Risk: Uncertainty of future market values and the size of future incomes, caused by fluctuations in the general level of interest.

•Inflation Risk: It is referred to uncertainties of purchasing power due to inflation.

Unsystematic Risk:-•It is that portion of risk which is caused due

to factors unique or related to a firm or industry.

•This type of risk can be eliminated by diversification of portfolio.

Reasons for occurring of unsystematic Risk

•External Business Risk: It arises due to change in operating conditions caused by conditions thrust upon the firm which beyond its control.

•Internal Business Risk: It is associated with the efficiency with which a firm conducts its operations within the broader environment imposed upon it.

•Financial Risk: It is associated with the capital structure of a firm.

The extent of financial risk depends on the leverage of the firm’s capital structure.

Investors’ Attitude to Risk:-•Common investors will have 3 possible

attitudes to undertake risky course of action ▫An aversion to risk.

▫A desire to take risk.

▫An indifference to risk.