Capital Budgeting under Risk and Uncertainties^131
risk situation is that the event is repetitive in nature and possesses a frequency
distribution. It is the inability to predict with perfect knowledge the course of future
events that introduces risk. As events become more predictable, risk is reduced.
Conversely, as events become less predictable, risk is increased. Thus, if Rs. 10 lakhs
is invested in stock of a company organised to extract coal from a mine, and then the
probable return cannot be predicted with 100 per cent certainty. The rate of return on
the above investment could vary from minus 100 per cent to some extremely high
figure and because of this high variability; the project is regarded as relatively risky.
Risk is then associated with project variability - the more variable the expected future
returns from the project, the riskier the investment.
In contrast, when an event is not repetitive and unique in character and the finance
manager is not sure about probabilities themselves, uncertainty is said to prevail.
Uncertainty is a subjective phenomenon. In such situation no observation can be drawn
from frequency distributions. We have no knowledge about the probabilities of the
possible outcomes. It follows that if the probabilities are completely unknown or are
not even meaningfully known the expected value of any decisions cannot be determined.
Practically no generally accepted methods could so far be evolved to deal with situation
of uncertainty while there are a number of techniques to deal with risk. In view of this,
the term risk and uncertainty will be used interchangeably in the following discussion.
With the introduction of risk no company can remain indifferent between two investment
projects with varying probability distributions as shown in Figure 6.1 Although each
investment inflows of Rs. 5,000 in its three-year life.Figure: 6.1 : Comparison of Probability DistributionProbability Occurance3000 0 3000 5000 7000 9000 11000Proposal BProposal A