132 Financial Management
A look at the Figure 6.1 will make it crystal clear that dispersion of the probability
distribution of expected cash flows for proposal B is greater than that for proposal A.
Since the task is associated with the deviation of actual outcome from that which was
expected, proposal B is the riskier investment. This is why risk factor should be given
due importance in investment analysis.
Sources of Risk
The first step in risk analysis is to uncover the major factors that contribute to the risk
of the investment. Four main factors that contribute to the variability of results of a
particular investment are cost of project, investment of cash flows, variability of cash
flows and life of the project.- Size of the Investment
A large project involving greater investments entails more risk than the small project
because in case of failure of the large project the company will have to suffer
considerably greater loss and it may be forced to liquidation. Furthermore, cost of a
project in many cases is known in advance. There is always the chance that the actual
cost will vary from the original estimate. One can never foresee exactly what the
construction, debugging, design and developmental costs will be. Rather than being
satisfied with a single estimate, it seems more realistic to specify a range of costs and
the probability of occurrence of each value within the range. The less confidence the
decision maker has in his estimate, the wider will be the range. - Reinvestment of Cash Flows
Whether a company should accept a project that offers a 20 per cent return for 2 years
or one that offers a 16 per cent return for 3 years would depend upon the rate of return
available for reinvesting the proceeds from the 20 per cent, 2-year period. The danger
that the company will not be able to reinvest funds as they become available is a
continuing risk in managing fixed assets and cash flows. - Variability of Cash Flows
It may not be an easy job to forecast the likely returns from a project. Instead of basing
investment decision on a single estimate of cash flow it would be desirable to have
range of estimates. - Life of the Project
Life of a project can never be determined precisely. The production manager should
base the investment decision on the range of life of the project.
Techniques for Handling Risk and Uncertainty
Risk analysis is one of the most complex and slippery aspects of capital budgeting.
Many different techniques have been suggested and no single technique can be deemed