(b) The terms risk and uncertainty are often used interchangeably but a distinction should be made
between them. With risk, there are several possible outcomes, which upon the basis of past relevant
experience, can be quantified. In areas of uncertainty, again there are several possible outcomes, but
with little past experience, it will be difficult to quantify its likely effects.
A risky situation is one where we can say that there is a 70% probability that returns from a project
will be in excess of $100,000 but a 30% probability that returns will be less than $100,000. If,
however, no information can be provided on the returns from the project, we are faced with an
uncertain situation. Managers need to exercise caution when assessing future cash flows to ensure
that they make appropriate decisions. If a project is too risky, it might need to be rejected, depending
upon the prevailing attitude to risk.
In general, risky projects are those whose future cash flows, and hence the project returns, are likely
to be variable. The greater the variability is, the greater the risk. The problem of risk is more acute
with capital investment decisions than other decisions because estimates of cash flows might be for
several years ahead, such as for new product development. Actual costs and revenues may vary well
above or below budget as the work progresses. |
