Analysis of Risk and Uncertainty

The analysis of risk and uncertainty is an important element in the capital budgeting decisions. The term risk refers to the variability of the actual returns from the expected returns in terms of cash flows.

The risk involved in capital budgeting can be measured in absolute as well as relative terms. The absolute measure of risk includes sensitivity analysis and standard deviation. The coefficient of variation is a relative measure of risk.

There are four recognised methods of incorporation of risk in the capital budgeting decision framework:

·         Risk-adjusted discount rate approach,

·         Certainty-equivalent approach,

·         Probability distribution approach, and

·         Decision-tree approach

According to the Risk-adjusted discount rate approach, the element of risk is incorporated through adjusting the required rate of return, using higher discount rates for riskier projects and lower discount rates for less risky projects. The Certainty-equivalent approach adjusts the risk through the cash flows associated with the projects. The Probability distribution approach illustrates the analysis of risk in capital budgeting through the application of probability theory. The Decision-tree approach takes into account the impact of all probabilistic estimates of potential outcomes. Every possible outcome is weighed in probabilistic terms and then evaluated.