Risk Analysis and Capital Budgeting- Certainty Equivalent Factor, Risk Adjusted Discounting Rate

RISK ANALYSIS IN CAPITAL BUDGETING

Since investment decisions are made on the basis of forecasts which depend on future events (cash inflows) and its occurrence can not be anticipated with absolute certainty because of economic, social, fiscal and political and other reasons.
Risk is the variation from its possible returns. Investment with govt. securities are risk free, whereas investment with shares of a company is risky as you can not say with certainty that the company will distribute the dividend at a given rate. So it is variability that may occur in future between estimated and actual returns.
The decision situations as to risk may be broken down into three types:
Certainty means no risk.
Uncertainty
Risk, is one where probabilities of a particular event occurring are known while uncertain situation is one where these probabilities are not known. In other words, in case of risk chance of future loss can be foreseen because of past experience. But in case of uncertainty future loss can not be foreseen.

Incorporation of risk factor

Now it is clear that a firm must take into consideration the risk factor while determining the return/cash flows from a capital budgeting decision. But incorporation of risk factor in capital budgeting decision is a difficult task. Some of the popular techniques used for this purpose are as follows:

(1) General techniques:

(a) Risk adjusted discount rate

(b) Certainty equivalent coefficient

(2) Quantitative techniques:

(a) Sensitivity analysis

(b) probability assignment

(d) Coefficient of variation

(e) Decision tree analysis.

RISK ADJUSTED DISCOUNTING RATE

It is based on the assumption that investors expect higher rate of return on risky projects as compared to less risky projects. This requires to calculate

(i) Risk free rate

(ii) Risk premium rate.

The risk free rate is used if there is no risk involved in the investment. Risk premium is the extra rate over the normal rate (risk free rate) on account being project risky.

Thus risk adjusted discount rate is the composite discount rate that takes into account time and risk factors. Higher discount for more risky and lower discount for less risky.