CHAPTER II

INVESTMENT DECISIONS
Introduction
• There are many risks in day to day life like accident, calamity, theft, loss due to certain other
causes.

• Similarly business also may be in loss in the future due to unforeseen or unpredictable
circumstances.

• Increased trade and financial activity across globe has led to most of the firms facing an
increased level of exposure.

• Exposure is the degree of sensitivity while risk is the degree of variability of concerned item
to any of the risk factor
Two factors can help in deciding how much
risky a situation is
• What is the probability of happening an event? (What kind of risk)

• How badly it is going to effect the aggrieves.? (what is the

consequence)

Risk is combination of two factors: risk and impact

Meaning of risk

• Risk is the chance or probability of loss, to others, it may be due to

uncertain situation.

• Risk is derived from Latin word 'resecare' where 're' means against
and 'secare' means to cut.

• Risk includes exposure to adverse (NOT FAVORABLE) situations.

Definition of risk
"Risk is a condition in which there is a possibility of an adverse deviation from a desired outcomes
that is expected or hoped so far. "

- Emmet J. Vaughan

Co X, which expects the profits of Rs.1,00,000 (desired outcome)

Adverse Deviation (away from what the co has expected)

The co actually earns a profit of Rs.70,000

Risk= Expected or Desired profits – Actual Profits

Risk= 1,00,000 – 70,000

Risk= 30,000
Uncertainty

• Risk and uncertainty is used interchangeably but they differ in

perception.

• Uncertainty involves a situation, about which likelihood of possible

outcome is not known. It cannot be quantified whereas risk can be
quantified of the likelihood of future outcomes.
Risk Vs Uncertainty

• Risk refers to situation where there is possibility of loss. Uncertainty is a situation

where the outcome is not certain or is unknown.

• There is lack of knowledge about what will happen or may not happen.Decision
making under certain situations is difficult.

• Risk outcome is known, uncertainty outcome is unknown.

• Risk is measured, Uncertainty cannot be measured.

• Decision making is easy in risk, not possible to make decision in uncertainty.

Causes of risk
• Wrong method of investment (diversify the investment)

• Wrong time of investment

• Wrong quantity of investment

• Interest rate risk (fluctuation of int rate.)

• Nature of investment instruments

• Nature and industry in which company is operating: manufacturing

Causes of risk

• Creditworthiness of the issuer

• Maturity period or length of investment

• Terms of lending

• National and international factors

• Natural calamities (Uncertainty)

Types of Risk

Broadly two types:

(i) Systematic Risk (Business is performing well but other factors is

causing the risk)

(ii) Unsystematic Risk (Business org is itself not performing well or it

has any financial crisis)
(i) Systematic Risk (Uncontrollable )

• Market risk (customers, competitors, govt, climate, natural calamities )

 Interest rate risk (fluctuation in the interest rate which is leading huge cash outflows)

 Purchasing Power Risk (Inflation and dep in the value of INR)

(ii) Unsystematic risk (Controlled)

• Business risk (products or services produced are not satisfactory from the customers point of
view)

• Financial risk (financial problem, running short of cash)(bankrupt, financial crisis )

• Credit or default risk (when business is not able to pay its own debt)

Other risks
Other Risks
• Individual and group risk
• Financial (loss) and nonfinancial risk (reputation, Goodwill)
• Pure (money oriented) and speculative risk
• Static (no change) and dynamic (huge fluctuation associated)risk
• Quantifiable (can be measured in terms of money) and non
quantifiable risk (co lost its reputation, customers perception on ur
company changed)
RISK ANALYSIS IN CAPITAL
BUDGETING
Capital budgeting is a process of identifying, analyzing and selecting investment to determine a
firm’s expenditures on assets whose cash flows are expected to extend beyond one year.

• Selecting and buying investment or fixed asset for the co.

• It including huge amount of cash

• Receiving a returns for longer period

It’s an important process because capital expenditures require large investment but limited by
the availability of funds (Capital Rationing), greatly influences a firm’s ability to achieve its
financial objectives, and can become as a tool of control
Risk and expected return

• Positive relationship (high risk = high returns and low risk= low returns) between
amount of risk assumed and the amount of expected return.

• Greater the risk larger the expected return and larger chances of substantial loss.

• A rational investor would have some degree of risk aversion, he would accept the
risk only if he is adequately compensated for.

• Most difficult problem for an investor is to estimate highest level of risk he is able
to assume
Risk and uncertainty in investment
decisions
The future cashflows are estimated based on the following factors:

• Expected economic life of the project/ machine.

• Salvage value/ Scrap value of the asset at the end of the economic life

• Capacity (how much of production in a day) of the project

• Selling price of the product

• Production cost (D. Material, D. Labor, D. OH)

• Depreciation rate of the machine

• Rate of taxation

• Future demand of the product, etc.

Techniques of measuring risk

(i) Risk-Adjusted Cut off Rate or Method of Varying Discount Rate:

• Simplest method of accounting for risk in capital budgeting is to increase the cut-off
rate or discount factor by certain percentage on account of risk.

• Project more risky and greater variability in expected return should be discounted at
higher rate than project less risky and variability in return

• Drawback – not possible to determine risk premium rate appropriately. Future cash
flows are uncertain and require adjustment not the discount rate.
(ii) Certainty equivalent method:

• Simple method of accounting risk in capital budgeting is to reduce

expected cash flows by certain amount.

• It can be employed by multiplying expected cash flows by certainty

equivalent co efficient as to convert uncertain cash flows to certain.
(iii) Sensitivity analysis:

• It is a technique in which sensitivity of profit or NPV or IRR to change in one

particular factor is checked.

• Only few factors may warrant management attention is embedded in this

analysis.

• Vital factors are identified as the make difference to the project.

• It is also called what if analysis.

• It involves a process of recalculating the NPV if particular factor turns out to be

different level than originally accepted.
Objective of sensitivity analysis

• To find answers to the questions such as what would happen to NPV.

• To identify those variables in the model

• To trace the variables about which future information is needed

Procedure involved insensitivity analysis:

• Setting relationship between basic factors

• Estimating the range of variation

• Studying the effect on NPV of variation

Assumptions of sensitivity analysis:

• Identifying the variables and there relationship

• It assess the strength or weakness of a given project

• It hints the need for future task.

Limitations of sensitivity analysis:

It studies the impact of one variable at a time

It is merely indicative providing no remedy

(iv) Probability approach

• It is relative frequency with which an event may occur in future.

• When future estimates of cash inflows have different probabilities the expected
monetary values may be computed by multiplying cash inflow with probability
assigned.

• Monetary values of inflows are further discounted to find out the present values.

• Project that gives higher values are accepted.

(v) Standard deviation method

• If two projects have same cost and there NPV are also the same SDs of the
expected cash inflows of two projects may be calculated to judge the comparative
risk of the projects.

• Projects with higher SD are more risky thank others.

• In this method deviations are squared making all values positive.

• The weighted average of these figures is taken, using probabilities on weights.

• The result is termed as variance. Converted to original by taking square root.

(vi) Coefficient of variation

• Standard deviation is an absolute measure of dispersion and may give

misleading results if alternative assets differ in size of expected
returns.

• In such cases co efficient of variation may be used as better measure

of risk.

• Risk per unit of expected return is calculated

(vii) Decision Tree Analysis
• In modern business complex investment decisions which involve a sequence of decisions
over time can be handled by plotting decision tree.

• It is graphic representation of relationship between a present decision and future events,

future decisions and their consequences.

Steps involved:

• Identifying the problem and alternatives

• Designing the decision tree

• Specifying probabilities and monetary values for outcomes

• Evaluating the alternatives