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Risk in Financing

In investment evaluation, risk occurs due to the occurrence of the possible future events with certainty and consequently, cannot make any correct prediction about the cash flow sequence. The inability of the decision-maker to make perfect forecasts give rise to risk. The risk associated with an investment may be defined as the variability that is likely to occur in the future returns from the investment. Risk is associated with the variability of future returns of a project. The greater the variability of the expected returns, the riskier the project. Risk can, however, be measured more precisely. The most common measures of risk are standard deviation and coefficient of variations.

A large number of events influence forecast. This event can be grouped in different water. However, no particular grouping of events will be useful for all proposes. We may for influencing the investment forecasts:

1. General economic conditions this category includes events which influence the general level of business activity. The level of business activity might ve affected by such events as internal and external economic and political situations, monetary and external economic and political etc.

2. Industry factors this category of events may affect all companies in an industry. For example, companies in an industry would be affected by the industrial relation in the industry, by innovations, by change in material cost etc.

3. Company factors this category of events may affect only a company. The change in management, strike in the company, a natural disaster such as flood or fire may affect directly particular company.

For example, if a person invests, say $20,000 in short-term government bonds, which are expected to yield 9 per cent return, he can accurately estimate the return on the investment. Such an investment is relatively risk-free. The reason for this belief is that government will not fail and will pay interest that the rate of interest paid on government securities, such sass short-term treasury bills, is the risk-free rate of interest. Instead of investing $20,000 in government securities, if the investor purchases the shares of a company, then it is not possible to estimate future return accurately. The return could be negative, zero of some extremely large figure. Because of the high degree of the variability associated with the future returns, this investment would be considered risky.

Forecasts cannot be made with perfection or certainty since the future events in which they depend are uncertain. An investment is not risky if we can specify a unique sequence of cash flows for it. But the whole trouble is that cash flows cannot be forecast accurately, and alternative sequences of cash flows can occur depending on the future events. To illustrate, let us suppose that a firm is considering a proposal to commit 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 conditions. It may be very sensitive to the general economic conditions and very low under unfavorable economic conditions. But, it is quite difficult to predict the future stat of economic conditions. Because of the uncertainty of the economic conditions uncertainty about the cash flows associated with the investment derives. Thus the investment would be profitable in the former situation and unprofitable in the latter case.