Risk Analysis of Single Investments 1.1 Sources of Risk There are several sources of risks in a project. The important ones are: Project-specific Risk The earnings and cash flows of the project may be lower than expected because of an estimation error or due to some other factors specific to the project like quality of management. Competitive Risk The earnings and cash flows of the project may be affected by the unanticipated actions of competitors Industry-specific Risk Unexpected technological developments and regulatory changes, that are specific to the industry to which the project belongs, will have an impact on the earnings and cash flows of the project as well Market Risk Unanticipated changes in macroeconomic factors like GDP growth rate, interest rate, and inflation have an impact on all projects, albeit in varying degrees.
International Risk In the case of a foreign project, the earnings and cash flows may be different than expected due to the exchange rate risk or political risk. 1.2 Measures of Risk Risk refers to variability. It is a complex and multi-faceted phenomenon. A variety of measures have been used to capture different facets of risk. The more important are: Range, Standard deviation, Coefficient of variation, and semi-variance. Perspectives on Risk: Regardless of the risk measure employed, there are different perspectives on risk, which are:- Stand-alone risk This represents the risk of a project when it is viewed in isolation Firm risk Also called corporate risk , this reflects the contribution of a project to the risk of the firm. Systemic risk/ market risk This represents the risk of a project from the point of view of a diversified investor.
The varieties of techniques developed to handle risk in capital budgeting fall into two broad categories: (i) Approaches that consider the stand-alone risk of a project( sensitivity analysis, scenario analysis, breakeven analysis, Hillier model, simulation analysis, and decision tree analysis ). (ii) Approaches that consider the contextual risk of a project (corporate risk analysis and market risk analysis).
What is risk? Risk is a situation where the possible events are known, but which of those will actually happen is not known. But, the probability of their occurrence can be determined. The term“RISK” is used to mean that though it is known how much the cash flows are likely to be, we can express realizability only through a probability distribution. Types of Risk: Business Risk : It can be defined as the variability of the earnings due to changes in the firm’s normal operating conditions. It has its origin in the impact of the changing economic environment on the firm’s activities and the management’s decisions on the capital intensity of the operations. Business risk is the variability of the EBIT and is therefore unconnected to the financial risk. In other words, business risk can be expressed as the possibility that the firm may not be able to compete in the market as effectively as planned to with the assets available with it.
Sub-types of business risk: 1. Investment Risk: It is the variability in the earning due to variations in cash in flows and out flows resulting from the capital investments made by the firm. 2. Portfolio Risk: It is also variation of the earnings but from a completely different perspective. As for example, the variability of the earnings caused by the diversification, acquisition, merger etc. Financial Risk: Variability of the after tax earning or the EPS of the firm caused by the financial structure, or precisely, the debt content in the capital structure. It is the impact of the efficient or otherwise use made by the firm to its long-term capital on the earnings of the firm.
The Entrepreneur’s Confrontation with Risk: Starting or buying a new business involves risk. The higher the rewards, the greater the risk entrepreneurs usually face. This is why entrepreneurs tend to evaluate risk very carefully. The figure illustrates the classification in terms of the financial risk endured when undertaking a new venture. The financial risk is measured against the level of profit motive, ( this is defined as the desire for monetary gain or return from the venture)with the characteristics or risk coupled with the type of activity. Profit – seeking activity is associated with the strong desire to maximize profit, and activity seeking refers to other activities associated with entrepreneurship, such as independence or the work of the venture itself. Types of Risk: 1. Financial Risk 2. Career Risk 3. Family and Social Risk 4. Psychic Risk
Typology of Entrepreneurial Styles Level of Personal Financial Risk Low High Low Risk avoiding Risk accepting Activity seeking Activity seeking Level of Profit Motive High Risk avoiding Risk accepting Profit seeking Profit seeking
It is argued that entrepreneurs vary in the relation between risk and financial return. This typology highlights the need to explore in economic theory the styles or entrepreneurial motivations that deviate from the styles most characterizing the rational person. “ If different entrepreneurial styles exist, then not every person who founds a new business does do by seeking to minimize financial return. Models of organization formation would thus have to be adjusted for differences among those who form organizations.” Thus, not all entrepreneurs are driven solely by monetary gain, and the level of financial risk cannot be completely explained by profit opportunity. Entrepreneurial risk is a far more complex issue than a simple economic risk-versus-return explanation. “ People who successfully innovate and start businesses come in all shapes and sizes. But they do have a few things others do not. They are willing to accept risk for what they believe in.”