UNIT 1: RISK – MEANING,

TYPES. RISK ANALYSIS IN

CAPITAL BUDGETING
 UNIT 1: RISK – MEANING, TYPES. RISK ANALYSIS IN CAPITAL BUDGETING 14
Hrs.

• Meaning of Risk.

• Types of Risks of a Business Enterprise.

• Risk Analysis in Capital Budgeting –

• Measuring and Managing Capital Budgeting Risks –

 Sensitivity Analysis,
 Scenario Analysis,
 Simulation,
 Standard Deviation and Co-efficient of Variation,
 Risk-Adjusted Discount Rate Method,
 Certainty Equivalent Co-efficient Method,
 Decision Tree Analysis and
 Probability Distribution Method
 Concept of Risk

Risk is expressed differently by different people.

To some, it is a chance or possibility of loss, to others, it may be uncertain

situations.

The word risk has been derived from the Latin word ‘resecare’ where, ‘re’ means
‘against’ and ‘secare’ means ‘to cut’.

It means to cut against or the part that is cut off or lost. Thus risk is losing
something or suffering loss due to future uncertainties.
• Risk is also derived from the early Italian word ‘risco’ which means ‘danger’ or
‘risicare’ which means ‘to dare’ or a French word ‘risque’.

• Risk is known or unknown but always inherent in individual or business actions

therefore it is more of a ‘choice’ other than fate accompli.

• In other words, it means that Risk is the potential that a chosen action will lead
to a loss or undesirable outcome. The idea implies that, a choice of having an
influence on the outcome exists.
Meaning of Risk

• Risk is a probability or threat of damage, injury, liability, loss or any other

negative occurrence that is caused by external or internal vulnerabilities and that
may be avoided through pre-emptive action.

• Risk means potential danger, insecurity, threat or harm of future event. In Finance
it refers to the probability that an actual return on investment will be lower than
the expected return.

• Risk is the potential variability of returns.

• An investment whose returns are fairly stable is considered to be a low risk

investment, whereas an investment, whose returns fluctuate widely are considered
to be risky investment.
Definition of Risk

• According to Hansson and Suen Oue, “Risk is the potential of losing something of
value, weighted against the potential of gaining something of value. Values such as
physical health, social status, emotional well being or financial wealth can be gained or
lost when taking risk resulting from a given action, activity and/or inaction, foreseen or
unforeseen”

• According to Emmett J. Vaughan, “Risk is a condition in which there is a possibility of

an adverse deviation from a desired outcome that is expected or hoped so far”.

• According to Harriaton and Michans, “At its most generous level, risk is used to
describe any situation where there is uncertainty about what outcome will occur”.

• According to Douglas, “Risk is the probability of an event combined with the

magnitude of the losses or gains that it will entail”.
 Types of Risks of a Business Enterprise

Risk can be classified into two broad categories;

Systematic Risk and Unsystematic Risk.

Systematic Risk

• It arises out of external and uncontrollable factors like changes in economic, political
and societal aspects. It is macro in nature as it affects a large number of organisations
operating under same domain.

• Changes in security’s total return are directly related to overall movements in general
market or economic condition.

• It cannot be controlled by an investor, it is critical to all investors.

Types of Systematic Risk:

a) Market Risk –

• It is associated with consistent fluctuations seen in the trading price of any particular
shares or securities. That is, it arises due to rise or fall in the trading price of listed shares
or securities in the stock market.

• Market price of shares move up or down consistently for time periods. A general rise in the
share prices are referred to bullish trend whereas a general fall in share prices is referred to
as bearish trend. In other words the shares market alternates between the bullish phase and
the bearish phase.

• The alternative movement can be easily seen in the movement of share price indices such
as the BSE Sensitive Index, BSE National Index, NSE Index etc.
b) Interest Rate Risk – It arises due to variability in the interest rates from time to time.

It particularly affects debt securities as they carry the fixed rate of interest.

The fluctuations in the interest rates are caused by the changes in the government
monetary policy and the changes that occur in the interest rates of treasury bills and the
government bonds.

The types of Interest Rate Risk are depicted and listed below:

i) Price Risk arises due to the possibility that the price of the shares, commodity,
investment, etc may decline or fall in the future.

ii) Reinvestment Rate Risk results from fact that the interest or dividend earned from an
investment cannot be reinvested with the same rate of return as it was acquiring
earlier.
c) Purchasing power or Inflationary Risk –

It is also called inflation risk since it emanates (originates) from the fact that it affects
purchasing power adversely. It is not desirable to invest in securities during an inflationary
period.

The two types of Inflationary Risk are as below:

i) Demand Inflation Risk arises due to increase in price, which result from an excess of
demand over supply. It occurs when supply falls to cope up with the demand and hence
cannot expand anymore. In other words, demand inflation occurs when production
factors are under maximum utilisation.

ii) Cost Inflation Risk arises due to sustained increase in the prices of goods and services. It
is actually caused by higher production cost. A high cost of production inflates the total
price of finished goods consumed by people.
Unsystematic Risk

• It occurs due to the influence of internal factors prevailing within an organisation.

• It is caused by factors like labour unrest, management policies, shortage of power,

recession in a particular industry, consumer preference etc. Such factors are
normally controllable from an organization’s point of view.

• It is micro in nature as it affects only a particular organization.

• It can be planned so that necessary actions can be taken by the organization to

mitigate (reduce the effect of) the risk.
 Types of Unsystematic Risk:

a) Business Risk –

• It refers to the possibility of inadequate profits or even losses due to uncertainties. It can
be internal as well as external. Internal business risk is caused due to absence of
strategic management improper product mix etc .

• Internal risk is associated with the efficiency with which a firm conducts its operation
with the broader environment.

• External business risk arises due to changes in operating conditions which are beyond
the firm’s control such as changes in preferences of consumers, strikes, increased
competition, changes in government policies, obsolesce, international market conditions
etc.
• Every business organisation contains various risk elements while doing the
business.

• Business risk implies uncertainty in profits or danger of loss due to some

unforeseen events in future, which causes business to fail.

• A company with a high business risk should choose a capital structure that
has a lower debt ratio to ensure that it can meet its financial obligation at all
times.

• The variation that occurs in the expected operating income indicates the
business risk.
b) Financial Risk –

• It is associated with the capital structure of the company. A company with no debt
financing has no financial risk. The extent of financial risk depends on the leverage
of the firm’s capital structure.

• Proper financial planning and other financial adjustments can be used to correct the
risk as it is controllable. It is the risk borne by the equity shareholders due to a firm’s
use of debt.

• If the company raises capital by borrowing money, it must pay back the money at
some future date plus financing charges.

• This increases the degree of uncertainty about the company because it must have
enough income to pay back this amount at some time in the future.
c) Credit or Default Risk –

• It arises due to default on fulfilling the duties of transaction by the parties or the
probability of loss from a debtor’s default. it is the risk of loss due to a debtor’s non-
payment of a loan or other line of credit either the principal or interest coupon or both.
The chances that the borrower will not pay can stem from a variety of factors.

• The borrower’s credit rating might have fallen suddenly and he became default prone
and in the extreme form may lead to insolvency. In such cases, the investor may get
no return or negative returns.

• Proper management of credit risk reduces the chances of non-payment of loan by the
borrowers and involves exploration by the company of ways and means of
encouraging prompt payment.
Other types of Risks:

a) Currency Risk – Exchange rate is volatile and risk arising from the change in price of
one currency against another is called currency risk or exchange rate risk. The constant
fluctuations in the foreign currency affect the investment made across the borders.
b) Country Risk – It arises from an adverse change in the financial conditions of a
country in which a business operates.

The three aspects of country risk are:

i) Political Risk
ii) Liquidity Risk
iii) Economic Risk
i) Political Risk – This is the risk of determining financial conditions from the
consequences of a change of government or political regime or from continuing
uncertainty about what the government might do? The risk is greater in countries
with political instability, because change in government could be sudden and the
actions of the incoming government are unpredictable and drastic eg the imposition
of exchange controls, nationalization of banks etc.

ii) Liquidity Risk – It refers to the possibility that the market for a security, such as
a bond or stock, might be illiquid, so that holders of the security could have
difficulty in selling their holding easily, should they wish to do so, at a fair price.

iii) Economic Risk – This is the risk that economic conditions within a country will
have harmful financial consequences, particularly for inflation, interest rates and
foreign exchange rates.
c) Taxability Risk – It refers to the risk associated with the changes made in tax rate. If
refers to the risk that the company faces that was issued with tax-exempt status could
potentially lose that status.

d) International Risks – These types of risks are faced by firms whose business consists
mainly of exports or those who procure their main raw material from international
markets.

e) Management Risk – Errors or constant changes made in the managerial decisions

affects the investors who have invested in the particular company. In other words it is
the risk arising out of managerial inefficiencies.
f) Technological Risk –

The changes in technology affect all the firms and the companies have to adopt
themselves in emerging into a new technology in order to survive.

g) Individual and Group Risks:

If a risk affects the economy or its participants at the macro basis, it is a group risk. These
risks affect most of segments of the society. These risks may be unemployment, war,
floods, earthquakes etc.

Individual Risks are confined to individual identities or small groups, Risks such as fire,
theft, robbery etc are individual risks. Some of the individual risks are insurable.
h) Pure and Speculative Risks:

Pure risks are those situations where the possibility of loss may or may not be there. If such
a risk is insured and loss arises then insurance company will compensate that loss. For
example, an insurance policy for a car is purchased, there is no accident during the period of
insurance policy, there will be no compensation, if damage occurs to car due to accident then
the insurer will indemnify the loss There is no situation of profit under such case.

Speculative Risks are those risks where there is a possibility of profit or loss. These risks are
undertaken with the intention of earning profit but profitability of loss also remains. An
investment in stock and shares may bring profit or loss. Pure risks have a possibility of
avoiding loss only whereas speculative risks have the possibility of gain also.
i) Static and Dynamic Risks:

Dynamic risks are those which are the outcome of changes in economy or the
environment. These risks mainly refer to macro- economic variables like inflation,
income and output levels, technological changes etc.

Dynamic risks emanate from the economic environment as these may not ne anticipated
or quantified.

Static risks are more or less predictable and are not affected by economic environment.
These risks are similar to pure risks and are suitable for insurance
j) Quantifiable and Non-quantifiable Risk –

The risks which can be measured like financial risks are quantifiable risks. Those risks
which may result in situation like tension, loss of peace etc are non-quantifiable.

k) Project-Specific Risk: It could be treated to something quite specific to the project.

Managerial efficiencies or error in estimated to a situation of actual cash flows realised
being less than the projected cash flows or discount rate may lead to a situation of actual
cash flows realised being less than the projected cash flows.

l) Industry-Specific Risk: It refers to that type of risk which affect all the firms in the
particular industry.
Risk Analysis in Capital Budgeting

• Risk analysis should be incorporated in capital budgeting exercise.

• The capital budgeting decisions are based on the benefits derived from the project.

• These benefits measured in terms of cash flows based on estimates. The estimation of future returns is
done on the basis of various assumptions.

• The actual return in terms of cash inflows depends on a variety of factors such as price, sales volume,
effectiveness of advertising, competition, cost of raw materials, manufacturing cost and so on. Each of
these in turn, depends on other variables like state of the economy, rate of inflation, etc.

• The accuracy of the estimates of future returns and the reliability of the investment decision would
largely depend upon the accuracy with which these factors are forecasted. l budgeting decisions".
The actual return will vary from the estimated return, which is technically referred to as
risk.

Thus risk with reference to investment decision is defined as "the variability in actual
returns arises from a project in future over its working life in relation to the estimated
return as forecast at the time of the initial capital budgeting decisions.
Why Risk Analysis is an Essential Aspect in Capital Budgeting ?

• For determining the validity of long-term investments, risk analysis is without equal in terms of providing measured
assessments of targeted risk factors.

• With today’s market uncertainty as well as the glaring unknown of the future, safeguarding and securing a company
with expert insights regarding investment outcomes is simply the smart way to do business.

• For example, if an organization is part of the IT industry, then a risk analysis can be useful to position technology-
related goals with a company’s business strategies.

• In capital budgeting, allocating resources towards necessary capital expenditures can result in increased value for
shareholders, but this is only applicable if a company has exercised wise investment practices.

• Risk analysis is, therefore, imperative in the context of long-term investment decision-making measures. By
constructing a process for appraising new opportunities, organizations can develop long-term objectives, estimated
future cash flows, and command capital expenditures.
Sensitivity Analysis:
Sensitivity Analysis:-

Sensitivity analysis is an important technique which helps the financial manager to know
what will happen to the outcomes of the project when some variable like sales or costs
deviates from its expected value.

Objectives of Sensitivity Analysis

Following are the basic objectives of sensitivity analysis:

(i) To Identify the Sensitivity Variables:

(ii) To identify the effect of Such Variables:
(iii) Trace the Variable about which Detailed Information is Required
Steps Involved in the use of Sensitivity Analysis:

(j) Identification of all those variables, which have an influence on the NPV or IRR of the
project.
(ii) Establish underlying mathematical relationship between these variables.
(iii) Analysis of the impact of the changes in each of the variables on the project’s NPV or
IRR.

Advantages of Sensitivity Analysis

(i) Identification of Variable

(ii) Helpful in Developing Alternative Plans
(iii) Assessment of Strength and Weakness
(iv) Indicates Need for Further Investigation
(v) Indicates the Areas of Improvement
(vi) Produce Useful Information about Projects
Limitation of Sensitivity Analysis

(i) Study of One Variable at a Time

(ii) Variables Changes in Arbitrary Manner
(iii) Does not Provide any Remedy
(iv) Subjective Analysis
(v) Does not Disclose the Probability
(vi) Variable may be independent
(b) Scenario Analysis:

In sensitivity analysis, typically one variable is varied at a time. If variables are interrelated, as they are
most likely to be, it is helpful to look at some plausible scenarios, each scenario representing a consistent
combination of variables.

Procedure:

1. Select the factor around which scenarios will be built. The factor chosen must be the largest source of
uncertainty for the success of the project. It may be the state of the economy or interest rate or
technological development or response of the market.

2. Estimate the values of each of the variables in investment analysis (investment outlay, revenues, costs,
project life, and so on) for each scenario.

3. Calculate the net present value and/or internal rate of return under each scenario.
Evaluation:

• Scenario analysis may be regarded as an improvement over sensitively analysis because it

considers variations in several variables together.

• It is based on the assumption that there are few well-delineated scenarios.

This may not be true in many cases. For example, the economy does not necessarily lie in three
discrete states, viz., recession, stability, and boom. It can in fact be anywhere on the continuum
between the extremes.

• Scenario analysis expands the concept of estimating the expected values.

Thus in a case where there are 10 inputs the analyst has to estimate 30 expected values (3 x 10) to do
the scenario analysis.
Simulation analysis:
• Sensitivity analysis and Scenario analysis are quite useful to understand the uncertainty of the
investment projects. But both the methods do not consider the interactions between variables.

• It differs from sensitivity analysis in the sense that instead of estimating a specific value for a key
variable, a distribution of possible values for each variable is used.

• The simulation model building process begins with the computer calculating a random value
simultaneously for each variable identified for the model like market size, market growth rate, sales
price, sales volume, variable costs, residual asset values, project life etc.

• From this set of random values a new series of cash flows is created and a new NPV is calculated.

• This process is repeated numerous times, perhaps as many as 1000 times or even more for very large
projects, allowing a decision-maker to develop a probability distribution of project NPVs.
From the distribution model, a mean (expected) NPV will be calculated and its associated standard
deviation will be used to gauge the project’s level of risk.

The distribution of possible outcome enables the decision-maker to view a continuum of possible
outcomes rather than a single estimate.

Merits:

• It facilitates the analysis and appraisal of highly complex, multivariate investment proposals with the
help of sophisticated computer packages.

• It can cope up with both independence and dependence amongst variables. It forces decision makers
to examine the relationship between variables.
Demerits:

• Simulation is not always appropriate or feasible for risk evaluation.

• The model requires accurate probability assessments of the key variables. E.g., it may be known that
there is a correlation between sales price and volume sold, but specifying with mathematical accuracy the
nature of relationship for model purposes may be difficult.

• Constructing simulated financial models can be time-consuming, costly and requires specialized skills.

• It focuses on a project’s standalone risk. It ignores the impact of diversification, i.e., how a project’s
stand-alone risk will correlate with that of other projects.

• Simulation is inherently imprecise. It provides a rough approximation of the probability distribution of

net present value.