Capital Budgeting under Risk and Uncertainties^157
diversification. Stable earnings and cash flows enable a firm to attract talent, to secure
greater commitment from various stakeholders, to exploit tax shelters fully, and to
check adverse managerial incentives. Hence most firms do look at the impact of
investment proposals, particularly the major ones, on the overall risk profile of the firm.Project Selection Under Risk
Once information about expected return (measured as net present value, or internal
rate of return or some other criterion of merit) and variability of return (measured in
terms of range or standard deviation or some other risk index) has been gathered, the
next question is: Should the project be accepted or rejected? There are several ways
of incorporating risk in the decision process: judgemental evaluation, payback period
requirement, risk profile method, certainty equivalent method, and risk adjusted discount
rate method.
Judgemental Evaluation
Often managers look at risk and return characteristic of a project and decide
judgementally whether the project should be accepted or rejected, without using any
formal method for incorporating risk in the decision making process. The decision may
be based on the collective view of some group group like the capital budgeting committee,
or the executive committee, or the board of directors. If judgemental decision making
appears highly subjective or haphazard, consider how most of us make important
decisions in our personal life. We rarely use formal selection methods or quantitative
techniques for choosing a career or a spouse or an employer. Instead, we rely on our
judgement.
Payback Period Requirement
In many situations companies use NPV or IRR as the principal selection criterion, but
apply a payback period requirement to control for risk. Typically, if an investment is
considered more risky, a shorter payback is required even if the NPV is positive or IRR
exceeds the hurdle rate. This approach assumes that risk is a function of time.
Ordinarily it is true that the further a benefit lies in future the more uncertain it is likely
to be because economic and competitive conditions tend to change over time. However,
risk is influenced by things other than the mere passage of time. Hence the payback
period requirement may not be an adequate method for risk adjustment or control.
Risk Profile Method
To use this method, we first transform the probability distribution of net present value,
an absolute measure, into the profitability distribution of profitability index, a relative
measure. To illustrate this transformation, let us consider the profitability distribution of
the net present value of a project, which involves an investment outlay Rs. 100,000