ADVANTAGES & DISADVANTAGES OF RISK ANALYSIS TECHNIQUES

PAYBACK PERIOD
Advantages
It is simple and easy to calculate PBP method is useful in weeding out risky projects PBP is a method of liquidity

Disadvantages
PBT fails to consider the time value of money It fails to measure risk which may be different for different projects It ignores cash flows beyond PBP and is a measure of projects capital recovery

RISK ADJUSTED DISCOUNT RATE

Advantages
RADR approach considers the time value of money and incorporates risk involved in the project RADR helps in finding out expected future wealth generated by a risk project over and above the RADR

Disadvantages
No easy way of deriving a risk-adjusted discount rate This method results in compounding of risk over time

CERTAINTY EQUIVALENT APPROACH

Advantages
It is conceptually superior to risk-adjusted discount rate approach

Disadvantages
Determination of CE factors, which may be subjective CE Approach explicitly recognizes risk but the procedure for reducing the forecasts of cash flow is implicit This method suffers from many dangers in a large enterprise

Contd..
Forecaster may inflate the forecasts If forecast have to pass through several layers of management, the effect may be to greatly exaggerate the original forecast By focusing attention on gloomy outcomes, chances of passing by some good investments.

SUMMARY & CONCLUSION

Risk in capital budgeting is the variability of actual returns from the expected To choose among investment projects, financial manager has to:
Estimate future cash flows for each project Evaluate the riskiness of those cash flows and Evaluate each projects contribution to companys value and hence to owners wealth

Know to incorporate risk into the analysis of projects to identify which ones maximize owners wealth

 Statistical tools to evaluate the risk of the projects cash flow are:
The range The standard deviation The co efficient of variation

Best business decisions may not yield the desired results Analysing the risks of the project to reduce the element of uncertainty in execution has become an essential aspect