Analysis of Risk and Uncertainty
The concept of risk and uncertainty is closely associated with capital budgeting decisions. Profitability and risk are closely related. It is very likely that a project that is potentially very profitable may also increase the perceived risk of the firm. This tradeoff between risk and profitability would have a bearing on the investors' perception of the firm. It is therefore, necessary to incorporate risk factor while making capital budgeting decision.
The capital budgeting decision is based on the future returns. The estimation of future returns is done on the basis of various assumptions and variety of factors. The accuracy of the estimates of future returns and therefore, the reliability of the investment decisions would largely depend upon the precision with which these factors are forecasted. There are strong reasons to believe that howsoever carefully these factors are forecasted, the actual returns will vary from the estimate. This is technically referred to as risk.
The risky situation is different from an uncertain situation. The risk situation is one in which the probabilities of a particular event occurring are known. These probabilities are not known under the uncertain situation.
Risk with reference to capital budgeting, results from the variation between the estimated and the actual returns. The greater the variability between these two, more risky the project.
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