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130 Financial Management

Risk is used to describe the type of situation in which there are a number of possible

states of nature, hence outcomes, but in which the decision maker can reasonably

assess the probability of occurrence of each. Thus risk can be expressed in quantitative

terms.

Under conditions of uncertainty, in contrast, it is recognised that several out-comes are

possible, but the decision-maker is unable to attach probabilities to the various states of

nature.

The liability is usually due to a lack of data on which to base a probability estimate. For

instance, in launching a new product, the marketing manager may have an idea of what

the sales in year 1 are likely to be, but he must accept that the actual level will be one of

many possible levels. However, the marketing manager may be unable to specify the

probability of each level being achieved, making it an uncertainty situation.

There is also, of course, the situation of complete certainty. This relates to a decision

over which the decision-maker has complete control, and is thus likely to be confined to

the production sphere. This is so because the existence of external agents in marketing

and distribution means that knowledge is incomplete, and the creative aspect of R & D

means that outcomes are unknown in advance.

If a finance manager feels he knows exactly what the outcomes of a project would be

and is willing to act as if no alternative were in existence, he will be presumably acting

under conditions of certainty. Thus, certainty is a state of nature, which arises when

outcomes are known and determinate. In this state each action is known to lead

invariably to a .specific outcome. For example, if one invests Rs. 20,000 in five yearly

central government bonds which is expected to yield 7 per cent tax free return, then

the return on the investment @ 7 per cent can be estimated quite precisely. This is so

because we assume the Government of India to be one of the most stable forces in

this country. Thus, the outcome is known to have a probability of 1. Since we know

how things are or will be, the decision strategy is deterministic, we simply evaluate

alternative actions and select the best one.

Risk involves situations in which the probabilities of an event occurring are known and

these probabilities are objectively or subjectively determinable. The main attribute of

Chapter-6

Capital Budgeting under Risk and Uncertainties