Risk analysis

Risk exists because of inability of decision maker to make perfect forecasts. Forecasts cannot be made with perfection or certainity since the future events on 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, & alternative sequence of cash flows can occur depending on future events. Thus, risk arises in investment evaluation because we cannot anticipate occurrence of possible future events with certainity & consequently, cannot make any connect prediction about cash flow sequence.

Techniques to handle Risk

    1. Pay back

    2. Risk-adjusted discount rate.

    3. Certainty equivalent.