Financial Management- Risk & Uncertainty

Brief explanation about concept of risk and uncertainty and it's practical sums with example.

1. METAS ADVENTIST COLLEGE

2. INDEX Definition of Risk Definition of Uncertainty Concept of risk and uncertainty in capital budgeting Techniques for Risk Analysis Risk-adjusted cutoff rate Variance or Standard Deviation Coefficient of Variation Certainly Equivalent Sensitivity technique Examples of techniques for Risk Analysis

3. RISK:- Risk is defined as unknowns that have measurable probabilities involving future events. In other words, a probabilistic estimate of how likely an event or exposure will be.

4. UNCERTAINITY:- Uncertainty refers to the difficulty of predicting outcomes of limited or inexact knowledge. 

5. In other words, a broad range of possible outcomes and complexity makes it impossible to define a set of probabilities. In general, other things being equal, a firm would be well advised to accept a project which is less risky and reject those that involve more risk.

6. Capital budgeting Based on benefits derived from projects Measured in terms of cash flows Estimation of future returns Cash inflows depends on a variety of factors Based on various assumption Sales volume, price, competition, cost of raw material etc

7. MEASUREMENT OF RISK: Sensitivity Analysis Assigning probability Simulation Precise measure of risk: Standard deviation & Coefficient of variation.

8. Sensitivity Analysis:- Sensitivity analysis helps a business estimate what will happen to the project if the assumptions and estimates turn out to be unreliable. In this way, it prepares the business's managers in case the project doesn't generate the expected results, so they can better analyze the project before making an investment.

9. Sensitivity analysis provides different cash flow estimates under three broad assumption:- The Worst (i.e. the most pessimistic) The Expected (i.e. the most likely) The Best (i.e. the optimistic) outcomes associated with project.

10. Illustration -1 : Compute the net present values (NPVs), of the two projects for each of the possible cash flows, using sensitivity analysis. Economic life year is 15 years .

11. Particulars Project “X” (‘000) Project “Y” (‘000) Initial cash outlays Rs.40 Rs.40 Cash inflows estimates: Worst 6 Most-likely 8 8 Best 10 16 Required rate of return 0.10 0.10

12. Standard Deviation: The standard deviation and the coefficient of variation are two such measures which tell us about the variability associated with expected cashflow in terms of degree of risk. Standard deviation is an absolute measure which can be applied when the project involve the same outlay.

13. In Statistical term, standard deviation is defined as the square root of the mean of the squared deviation, where deviation is the difference between an outcome and the expected means value of all outcomes. Further to calculate the value of standard deviation, we provide weights to the square of each deviation by its probability of occurrence.

14. Sr. no Cash Inflows (in Rs) ( i ) 1 6,500 2 5,600 3 2,150 4 4,750 Rs = 19,000 Mean = 4,750 PROJECT -1

15. PROJECT- 2 Sr. no Cash Inflows Deviation from mean Squaring of deviation Prob - ab ility Weighted deviation ( i ) (ii) (iii) = (ii)² (iv) (v) = iii x iv 1 4,000 750 5,62,500 0.1 56,250 2 4,500 250 62,500 0.4 25,000 3 5,500 750 5,62,500 0.4 2,25,000 4 5,000 (250) 62,500 0.1 6,250 Rs = 19,000 N = 1 Rs = 312500 Mean = 4,750 Standard Deviation

16. Assigning Probability: The concept of probability is very helpful as it indicates the percentage chance of occurrence of each possible cash flow. For instance, if some expected cash flow has 0.6 probability of occurrence, it means that given cash flow is likely to be obtained in 6 out of 10 times (i.e. 60 percent). With zero (0) probability, the cash flow estimate will never materialize. Thus, probability of obtaining particular cash flow estimates would be between zero to one.

17. Years Project - 1 Proba-bility Project - 2 Proba-bility Initial Investment 10,000 10,000 1 15,000 0.2 12,000 0.2 2 18,000 0.4 15,000 0.4 3 12,000 0.4 13,000 0.4 Cost of Capital = 10%

18. RISK EVALUATION APPROACHES Risk Adjusted Discount Rate method Certainly Equivalent Approach Decision-tree Approach

19. Risk Adjusted Discount Rate Method: This method has a certain virtues in capital budgeting analysis. It is simple to calculate and easy to understand because companies in actual practice apply different standards of cost of capital for different projects.

20. Certainly Equivalent Approach The certainly-equivalent approach (CEA), as an alternative to the risk-adjusted method, over comes some of the weakness of the latter method. Under the former approach the riskiness of the project is taken into consideration by adjusting the expected cash flows and not the discount rate. This method eliminates the problem arising out of the inclusion of risk premium in the discounting process.

21. Decision-tree Approach A decision tree approach is another useful alternative for evaluating investment proposals. A decision tree is a pictorial representation in a tree form which indicates the magnitude, the probability and inter-relationship of all possible outcomes.

22. PRESENTED BY : Shaleeni Dodawala - D208 Vandna Marothi - M273 Dhara Rank- R110 Ikrabanuu Shaikh - S380