Under Section, "business risk complexion" of the firm was mentioned. In that discussion, it was held that suppliers of capital could hold the view that the selection of any investment project may not alter, the business-risk complexion of the firm. Thus, risk was held constant; and based on this, the expected future cash flows were analysed. But it is likely that the risk-free assumption is not always either correct or is realisable. Suppliers of capital to the firm (investors and creditors), by and large, are risk-averse; and hence, the least they may do, short of totally withdrawing from supplying capital is, to suitably change their required rate of return as the risk-perception changes.
The risk-profile of a project's future cash inflows affects also the firm's value. For example, a project expected to provide a high return may be so risky that the suppliers of capital may consider the firm as risky resulting in decrease in the firm's value inspite of even a good profitability potential.
In the earlier units and sections, the relationship between profitability and risk has been repeatedly described and demonstrated. Likewise, it is necessary to incorporate the risk factor in project evaluation/apprisal as well as in the accompanying capital investment decisions.
Rather than covering the risk of the firm as a whole, only the project risk is discussed in the ensuing section. The purpose is to understand how risk affects value. Several occasions exist where the terms risk and uncertainty are used synonymously notwithstanding the differences between the concepts. Risk is describable by a probability distribution but uncertainty is not.
Description of Risky Investment
First of all, it is necessary to evaluate risky investments. For this, the benefits must be estimated. The term"estimating" itself mirrors out the role of various assumptions - e.g., prices, sales volumes, competitions, effectiveness of advertising and interaction with beneficiaries, clients and customers, several categories of costs, state of the economy, infrastructure, power supply, etc. The actual returns will vary from the estimates in many a case. This variation is the underlying factor in project risk. The greater the variability, the riskier the project and the returns on its investment. But yet one must be able to consider a range of possible cash flows. It must, of course, be emphasised, that any probability description of the range of expected cash flows will only be subjective - after all, the cash flows are yet expected and are not part of a series of past-recorded data, but, based on past experience under comparable circumstances, and well aware of the emerging trends and situations, the concerned group makes the best possible range of estimates along with the probabilities of occurrence of each of the estimated values over the whole range. In continuation of what has been said earlier, it is, of course, true that estimates of returns from cost-reduction type of capital budgeting will be less risky than income-expansion type of capital budgeting. It can also be retold that the greater the range, or the spread, or the estimated values for any one outcome, the greater the riskiness of that outcome.
Description of Risky Investment
First of all, it is necessary to evaluate risky investments. For this, the benefits must be estimated. The term"estimating" itself mirrors out the role of various assumptions - e.g., prices, sales volumes, competitions, effectiveness of advertising and interaction with beneficiaries, clients and customers, several categories of costs, state of the economy, infrastructure, power supply, etc. The actual returns will vary from the estimates in many a case. This variation is the underlying factor in project risk. The greater the variability, the riskier the project and the returns on its investment. But yet one must be able to consider a range of possible cash flows. It must, of course, be emphasised, that any probability description of the range of expected cash flows will only be subjective - after all, the cash flows are yet expected and are not part of a series of past-recorded data, but, based on past experience under comparable circumstances, and well aware of the emerging trends and situations, the concerned group makes the best possible range of estimates along with the probabilities of occurrence of each of the estimated values over the whole range. In continuation of what has been said earlier, it is, of course, true that estimates of returns from cost-reduction type of capital budgeting will be less risky than income-expansion type of capital budgeting. It can also be retold that the greater the range, or the spread, or the estimated values for any one outcome, the greater the riskiness of that outcome.
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