Financial risk

From ArticleWorld

The Financial risk is generally considered before starting business and investing any funds. After starting the business the decision maker has to make perfect forecasts, otherwise chances of losses will increase. When the decision maker is unable to forecast properly the risk will increase. An investment is not risky, if we can specify unique sequence of cash flows for it. But the forecast of cash flows depends on future events which are uncertain. To illustrate, let us suppose that a firm is considering a proposal to invest its funds in a machine which will help to produce a new product. The demand for this product may be very sensitive to the general economic conditions. It may be very high under favorable economic condition and very low under unfavorable economic condition. Thus the investment would be profitable in former situation and unfavorable in the later case. But it is quite difficult to predict the future state of economic conditions. Because of uncertainty of economic conditions, uncertainty about the cash flows associated with investment comes into existence.

A large number of events influence forecasts. The major events are (1) General economic conditions (2) Industry factors (3) Company factors

A number of techniques to handle risk are used by managers in practice. They range from simple rules of thumb to sophisticated statistical techniques. The popular and non-conventional techniques of handling risk in capital budgeting are (1) Payback (2) Risk adjusted discount rate (3) Certainty equivalent These methods are simple familiar and defensible on theoretical grounds.

Following factors influence the risky nature of investment in projects: (1) Price of raw materials and other inputs (2) Price of product (3) Product demand (4) Government policies (5) Technological changes (6) Project Life (7) Inflation

The most commonly used method of risk analysis in practice are (1) Sensitivity analysis which allows to see the impact of change in the behavior of critical variables on the project profitability (2) The conservative forecasts include using short payback or higher discount rate for discounting cashflows.