The Risk associated with a project may be defined as the variability that is likely to occur in the future returns from the project. Risk arises in investment evaluation because we cannot anticipate the occurrence of the possible future events with certainty and consequently, cannot make any correct prediction about the cashflow sequence.
Attitudes towards Risk
Three possible attitudes towards Risk can be identified. These are:
(a) Risk aversion
(b) Desire for Risk
(c) Indifference to Risk
A Risk averter is an individual who prefers less risky investment. The basic assumption in financial theory is that most investors and managers are risk averse.
Risk seekers on the other hand are individuals who prefer risk. Given a choice between more and less risky investments with identical expected monetary returns, they would prefer the riskier investment.
The person who is indifferent to risk would not care which investment he or she received.
To illustrate the attitudes towards risk assume two projects are available. The cashflows are not certain but we can assign probabilities to likely cashflows as shown below.
States of nature Project A's Project B's Probability
Optimistic prediction Sh 900,000 600,000 0.2
Moderate prediction 600,000 600,000 0.6
Pessimistic prediction 300,000 600,000 0.2
The expected cashflow would be computed as follows:
Expected cashflow = 900,000 (0.2) + 600,000 (0.6) + 300,000 (0.2)
= Sh 600,000
Expected cashflow = 600,000 (0.2) + 600,000 (0.6) + 600,000 (0.2)
= Sh 600,000
Therefore, the two projects have the same expected cashflows (Sh 600,000). However, Project A is a riskier project since there is a chance that the cashflow will be Sh 300,000. Project B on the other hand is a less risky project since we are sure that Sh 600,000 will be received.
A risk seeker would choose Project A while a risk averter would choose Project B. A risk neutral decision maker would be indifferent between the two projects since the expected cashflows are equal.