Finance

Overview on Uncertainty (Risk) in Investments

Background

Up until now, we have assumed that we will receive each payment with absolute certainty, as if we have received a guarantee from the US government. This situation is referred to as guaranteed income. Unfortunately, however, in most projects, the income is not guaranteed.

Situations are possible during which we will not receive all (or some) of the planned income, or we will receive it late, or the income will be less than had been expected. When we lack complete assurance that any flow of income will be received as planned, we say that the results of the project are accompanied by uncertainty.

In the business world, a situation of uncertainty is regarded as risk, although positive surprises are equally possible in these situations. It is therefore more correct to regard situations of uncertainty as involving risk-reward, not just risk.

Ramifications of Uncertainty for Decision-MakingIn this section, we will provide an initial acquaintance with the main tools used in the theory of finance to handle uncertainty. These are:

1. Average 2. Standart deviation 3. Beta

At the same time, we will focus on the distinction between two types of risk:

systematic risk and specific risk.

During the preliminary stage, we will emphasize that one of the more popular ways of dealing with uncertainty about receiving any flow of income is by adding some percentage to the capitalization interest rate (for calculating the present value), for example, 3%.

Had the capitalization interest rate of the project that had its income ensured by a federal guarantee been 15%, then the rate would have risen by 3% to 18% without a federal guarantee.

Examples of the Effect of Increased Interest

We will examine the effect of increasing the interest rate on the viability of investments in the oil projects which were proposed. When we assumed that the income was guaranteed, the capitalization interest was 10%.

Now we assume that we no longer have security for the payments. We therefore decide to add 5% to the capitalization interest, which brings the figure to 15%. We will calculate the present value of the flow of income according to two alternatives:

  • Alternative 1: Guaranteed income with 10% capitalization interest.

  • Alternative 2: Non-guaranteed income with 15% capitalization interest.

The results are presented on the next Table.


Table 2.9

Calculation of the present value of a flow of income according to two alternatives


Project No. 1

Project No. 2

Project No. 3

Sum of Investment

$1.00 million

$1.00 million

$1.00 million

Guaranteed income (10%) (Present value with 10% capitalization interest.)

$1.10 million

$1.12 million

$0.86 million

Non-guaranteed income (15%) (Present value with 15% capitalization interest.)

$0.97 million

$1.02 million

$0.80 million

Overview on Uncertainty (Risk) in Investments541Overview on Uncertainty (Risk) in Investments