Risk Analysis in CapitalBudgetingBy: Vikram.G.BLecturer, P.G dept. of CommerceV.D.C, Bangalore-55
Risk & uncertainty:-• Uncertainty is a situation where a decision canlead to more than one possible outcome.• Risk exists because of the inability of thedecision maker to make perfect forecast.• Traditional difference between Risk &Uncertainty is▫ uncertainty cant be quantified whilst risk can.
• Risk is concerned with the use of quantificationof the likelihood of future outcomes.• Uncertainty is to cover all future outcomeswhich cannot be predicted with accuracy.
Why Risk Arises in Investment Evaluation?• Because unable to anticipate occurrence of thepossible future events with certainty andconsequently.• Unable to make correct prediction about thecash flow sequence.
Categories of Risk:-RiskUnsystematicRiskBusinessRiskInternalExternalFinancialRiskSystematicRiskMarket Risk Interest Risk InflationRisk
Systematic Risk:-• It relates to economic trend whichs affect thewhole market.• It is a that portion of variation in return causedby the factors that affect the prices of allsecurities and it can’t be avoided.• The effect in a systematic return causes theprices of all individual shares/bonds to move inthe same direction.
Reasons for occurring of Systematic Risk• Market Risk: Variations in price sparked off due toreal social, political and economic events.• Interest Rate Risk: Uncertainty of future marketvalues and the size of future incomes, caused byfluctuations in the general level of interest.• Inflation Risk: It is referred to uncertainties ofpurchasing power due to inflation.
Unsystematic Risk:-• It is that portion of risk which is caused due tofactors unique or related to a firm or industry.• This type of risk can be eliminated bydiversification of portfolio.
Reasons for occurring of unsystematic Risk• External Business Risk: It arises due to changein operating conditions caused by conditionsthrust upon the firm which beyond its control.• Internal Business Risk: It is associated with theefficiency with which a firm conducts itsoperations within the broader environmentimposed upon it.
• Financial Risk: It is associated with the capitalstructure of a firm. The extent of financial risk depends on the leverageof the firm’s capital structure.
Investors’ Attitude to Risk:-• Common investors will have 3 possible attitudes toundertake risky course of action▫ An aversion to risk.▫ A desire to take risk.▫ An indifference to risk.