156 Financial Management
l The probabilities and the cash flows associated with various outcomes can be
specified at the beginning of the project. This means that the firm has experience
of doing similar projects in the past.
Obviously, decision tree analysis requires enormous information before it can be applied.
The oil drilling project is one case where the required information may be available.
However, it may be much more difficult to apply decision tree analysis to a project
where the product or service is new and the firm has very little information on how
the market will respond to it. Decision trees are not easy to when investments are
gradually made over a period of time rather than in a few well-defined stages.Corporate Risk Anslysis
A projectís corporate risk is its contribution to the overall risk of the firm. Put differently,
it reflects the impact of the project on the risk profile of the firmís total cash flows.
We know that the contribution of a security to portfolio risk depends on (i) the standard
deviation of its returns and (ii) the correlation of its returns with the returns on the other
securities included in the portfolio. In the same way, the corporate risk of a project
depends on (i) the standard deviation of its returns and (ii) the correlation of its returns
with the returns on the other projects of the firm.
On a stand-alone basis a project may be very risky but if its returns are not highly
correlated or, even better, negatively correlated with the returns on the other projects
of the firm, its corporate risk tends to be low.
Aware of the benefits of portfolio diversification, many firms consciously pursue a
strategy of diversification. Hindustan Lever Limited, for example, has a diversified
portfolio comprising, in the main, the following businesses: soaps and detergents, personal
care products, edible oil, and tea.
The proponents of diversification argue that it helps in reducing the firmís overall risk
exposure. As most businesses are characterised by cyclicality it seems desirable that
there are at least two to three different lines of business in a firmís portfolio. As
someone put it vividly. ìIf you have three legs to your firm, you enjoy a reasonable
degree of stability.î This is simply another way of saying that donít put all your eggs
in the same basket.
The logic of corporate diversification for reducing risk, however, has been questioned.
Why should a firm diversify when shareholders can reduce risk through personal
diversification. All that they have to do is to hold a diversified portfolio of securities or
participate in a mutual fund scheme. Indeed, they can do it more efficiently.
There does not seem to be an easy answer. Although shareholders, can reduce risk
through personal diversification there are some other benefits from corporate