Risk is inherent in almost every business decision. More so in capital budgeting decision as they involve costs and benefits extending over a long period of time during which many things can change in unanticipated ways. A research and development project may be more risky than an expansion project and the latter tends to be more risky than a replacement project. In view of such differences,
variations in risk need to be considered explicitly in capital investment appraisal. Risk analysis is one of the most complex and slippery aspects of capital budgeting.
Perspectives on Risk
You can view a project from at least three different perspectives:
Stand alone risk- This represents the risk of a project when it is viewed in isolation.
Firm risk- Also called corporate risk; this represents the contribution of a project to risk: the firm.
Market risk- This represents the risk of a project from the point of view of a diversified investor. It is also called systematic risk.
Since the primary goal of the firm is to maximize shareholder value, what matters finally is the risk that a project imposes on shareholders. If shareholders are well diversified market risk is the most appropriate measure of risk.
In practice, however, the project’s stand-alone risk as well as its corporate risk are considered important. Why? The project’s stand-alone risk is considered important-for the following reasons:
- Measuring a project’s stand-alone risk is easier than measuring its corporate risk a, far easier than measuring its market risk.
- In most of the cases, stand-alone risk, corporate risk, and market risk are correlated. If the overall economy does well, the firm too would do well.
- The proponent of a capital investment is likely to be judged on the performance of that investment.
- In most firms, the capital budgeting committee considers investment proposals one at a time.
Corporate risk is considered important for the following reasons:
- Undiversified shareholders are more concerned about corporate risk than market risk.
- Empirical studies suggest that both market risk and corporate risk have a bearing on required returns. Perhaps even diversified investors consider corporate risk in addition to market risk when they specify required returns.
- The stability of over-all corporate cash flows and earnings is valued by managers, workers, suppliers, creditors, customers, and the community in which the firm operates. If the cash flows and earnings of the firm are perceived to be highly volatile and risky, the firm will have difficulty in attracting talented employees, loyal customers, reliable suppliers, and dependable lenders. This will impair its performance and destroy shareholder wealth.
Recognizing the importance of stand-alone risk, firm risk, and market risk, we will discuss risk from all the three perspectives.
Causes of Risk
- Insufficient number of similar investments – Thus opportunity for outcomes to average out
- Bias in data and its assessment
- Changing external economic environment invalidating past experiences
- Misinterpreting data
- Errors of analysis
- Managerial talent availability and emphasis
- Salvageability of investment
Methods of Dealing with Risk in Capital Budgeting
Different techniques have been suggested and no single technique can be deemed as best in all situations. The variety of techniques suggested to handle risk in capital budgeting fall into two broad categories:
- Approaches that consider the standalone risk of a project
- Approaches that consider the risk of a project in the context of the firm or in the context at the market.
This chapter discusses different techniques of risk analysis explores various approaches to project selection under risk, and describes risk analysis in practice. The techniques are discussed in the following order
- Risk adjusted discount rate approach
- Certainly equipments approach
- Sensitivity analysis
- Scenario analysis
- Breakeven analysis
- Hillier model
- Simulation analysis
- Decision tree analysis
- Corporate risk analysis