106 Financial Management
Companies in India consider the following as the four most important contributors of
investment risk: selling price, product deman4 technological changes and government
policies. India is fast changing from sellersí market to buyersí market as competition
is intensifying in a large number of products; hence uncertainty of selling price and
product demand are being realised as important risk factors. Uncertain government
policies (in areas such as custom and excise duty and import policy), of course, , a
continuous source of investment risk in developing countries like India.
Sensitivity analysis and conservative forecasts are two equally important and widely
used methods of handling investment risk in India. Each of these techniques is used
by a number of Indian companies with other methods while many other companies use
either sensitivity analysis or conservative forecasts with other methods. Some companies
also use shorter payback and inflated discount rates (risk-adjusted discount rates).
In US4 risk adjusted discount rate is used by 90 per cent companies while only 10 per
cent use payback and sensitivity analysis. This is also confirmed by another US study
by Petty and Scott (1981). In Rockleyís survey of the British companies only one firm
out of 69 used sensitivity analysis.3 The contrasts in risk evaluation practices in India,
on the one hand, and USA and UK, on the other, are sharp and significant. Given the
complex nature of risk factors in developing countries, risk evaluation cannot be handled
through a single number such as NPV calculation based on conservative forecasts or
risk-adjusted discount rate. Managers must know the impact on project profitability of
the full range of critical variables. Hastie, an American businessman, strongly advocates
the use of sensitivity analysis for risk handling and casts doubt on the survey results
in USA. He states: ëthere appear to be more corporations using sensitivity analysis
than surveys indicate. In some cases firms may not know that what they are undertaking
is called ësensitivity analysisí, and it probably is not in the sophisticated, computer
oriented sense.....................Typically, analysts or middle managers eliminate the
alternative assumptions and solutions in order to simplify the decision making process
for higher managementî
Capital Rationing
Indian companies, by and large, do not have to reject profitable investment opportunities
for lack of funds, despite the capital markets not being so well developed. This may
be due to the existence of the government-owned financial system which is always
ready to finance profitable projects. Indian companies do not use any mathematical
technique to allocate resources under capital shortage which may sometimes arise on
account of internally imposed restrictions or managementís reluctance to raise capital
from outside. Priorities for allocating resources are determined by management, based
on the strategic need for and profitability of projects.