A basic assumption in capital budgeting decisions is this that the project cashflows are known with certainty. In actuality there are very few capital budgeting projects for which the cash inflows are perfectly certain. An example of such decision is that of purchase of a plant and then its sub-lease.
But as a general rule, future is never certain and the estimation of only one set of cash-flows for each year is highly unrealistic. Of course, had the future been certain the application of a particular method of only one set of figures to evaluate the profitability would have given accurate result and the whole process of capital budgeting would have been much simpler. But, because of the various risks and uncertainties associated with each investment proposal, the outcome is more likely to be different from the predicted one.
‘Risk involves situations in which the probabilities of a particular event occurring are known; whereas with uncertainty, these probabilities are not known. However, for the purpose of this analysis, no distinction is made between risk and uncertainty and the use interchangeably. In formal terms, the risk associated with a project may be defined as the variability that is likely occur in the future returns from the project.
A wide range of factors give rise to risk and uncertainty in capital investment, viz., competition, technological development, changes in consumer preferences, economic factors, both general and those peculiar to the investment, political factors, etc. The certain outcome of these factors is that the revenues costs and economic life of a particular investment are less than certain.
Benjamin Frankin stated : ‘But in this world nothing can be said to be certain except death and taxes.’ It may be added that though tax is certain the amount of tax is uncertain. A firm’s ability to make the correct accept-reject decision for a new asset depends on its ability to perceive future events which affect the profitability of the asset. The key factor in any risk and uncertainty evaluation is how the firm perceives the risk and most firms are averse.
Generally, firm may he satisfied with a small expected return from an investment if the uncertainty connected with it is also small and the firm may be attracted to high yielding investments and ignore the uncertainty connected with income from We investment. Stated in other words, higher the profitability normally, higher is the risk associated with it and vice versa. The two elements of uncertainty to be considered in making a capital expenditure decision are (a) what is the profitability that the estimate of cash-flows correct and (b) what is the effect on projected profit if the actual events differ from predicted events ?
A capital expenditure decision may not be sound, if taken on the basis of only one set of assumptions as regards the profitability, without perceiving the risk and uncertainty connected with the assumptions. Well then, how the firm perceives uncertainty. There are different techniques developed for the purpose, both simple and highly complicated and mathematical. Common and non-mathematical techniques are (1) Risk Adjusted Rate of Return and (2) Certainty Equivalents (CE).