PROJECT SELECTION UNDER RISK

Once information about expected and variability of return has been gathered, the next question is should the project be accepted or rejected?. There are several ways of incorporating risk in the decision process. Judgmental evaluation, payback period requirement, risk adjusted discount rate, and certainty equivalent.

Judgmental Evaluation

Often managers look at the risk and return characteristics of a project and decide judgmentally whether the project should be accepted or rejected, without using any formal method for incorporating risk in the decision making process. The decision may be based on the collective view of  some group like the capital budgeting committee or executive committee or the boar of directors. If judgmental decision making appears highly subjective or haphazard, consider how most of us make important decision in our personal life. We rarely use formal selection methods or quantitative techniques for choosing a career or spouse or an employer. Instead we rely on our judgement.

Payback Period Requirement

In many situations companies use NPV or IRR as the principal selection criterion, but apply a payback period requirement to control for risk. Typically if an investment is considered more risky, a shorter payback period is required even if the NPV is positive or IRR exceeds the hurdle rate. This approach assumed that risk is a function of time 

Ordinarily it is true that father a benefit lies in future the more uncertain it is likely to. E because economic and competitive conditions tend to change over time. However risk is influenced by things other than the mere passage of time. Hence the payback period requirement may not be an adequate method for risk adjustment or control.

Risk adjusted discount rate

The risk adjusted discount rate method calls for adjusting the discount rate to reflect project risk. If the risk of the project is equal to the risk of the existing investments of the firm, the discount rate used is the average cost of capital of the firm, I f the risk of the project is greater than the risk of the existing investments of the firm, the discount rate used is higher than the average cost of capital of the firm. If the risk of the project is less than the risk of the existing investments of the firm the discount rate used is less than the average cost of capital of the firm.