Business Risk: Types, Measurement and Measures for Reducing It

Let us make an in-depth study of Business Risk:-

1. Definition of Risk 2. Types of Risk 3. Measurement 4. Measuring for Reducing 5. Evaluation Approaches.

Definition of Risk:

The word ‘Risk’ is of great importance in business and business activities. The business activity is full of Risk. To earn profit in business one will have to take risk.

Various authors of economics have defined “Risk” and the important of them are as follows:

1. According to Milton H. Spencer:

“Risk has been defined as a state of knowledge in which each alternative leads to one of a set of specific outcomes each occurring with a probability that is known to the decision-maker.”

2. Regarding ‘Risk’, Haynes, Mote and Paul has written:

“Risk refers to relatively objective probabilities which can be computed on the basis of past experience or some prior principle.”

3. Management School of London has defined Risk as such:

“Risk is the investment decisions together with the variability in the actual returns emanating from a project in future over its working life in relation to the estimated return as forecast at the time of initial capital budgeting decisions.”

Types of Risk:

Important types of Risk are as follows:

1. Business Risk:

Business Risks are those which are related with the production, marketing and personnel affairs of a business firm. There are risks concerning tastes and preferences of customers, policies of competitors, business cycles, labour strikes, price policy of the firm etc. If Uncertainty in this regard is measurable it becomes business risk.

2. Financial Risk:

These types of risks are related with financial activities and decisions of a firm. Financial decisions determine the financial risk of a firm. Financial risks relate to the risk of possible fluctuations in the profit, risk of bad debts and the risk of possible insolvency. Financial risk is reflected in the prices of shares.

3. Portfolio Risk:

Portfolio risks are those that are derived from various investment proposals and their effect on the financial structure of a firm. Portfolio risks are insurable.

Measurement of Risk:

There are two methods of measuring probability of Risk. They are:

1. Deduction method or Priori Principle.

2. Past Experience Method or Posteriori Principle.

1. Deduction Method or Priori Principle:

Under this method, the probability of risk is measured on the basis of “imaginary principles”. No past experience is used for help.

For example:

If a firm is engaged in illegal business, it is always possible that it will be punished sooner or later. It is always possible to loose in the transactions of speculation. In this there is no certainty of these measurements however, the results of these measurements are always expected to be within a certain limit.

2. Past Experience Method or Posteriori Principle:

In this method the help of past experiences is taken to measure the probability of risk. This method is based on the assumption that “History repeats itself.” Here it is assumed that the past incidents will occur again therefore past experience can be used to predict the probability of Risk.

For example:

In­surance company determines the rate of premium on the basis of calculation of Death Rate.

Measures for Reducing Risk:

There are two methods normally used:

1. Internal Planning for Reducing Risk:

When a business firm makes all the possible efforts to reduce the risk on its own it is called internal planning for risk. No external source is used to reduce the risk in this case.

For example:

(a) If a firm, 10% of the quantity of raw materials introduced is wasted, the firm will prepare plan for reducing such wastage to the minimum.

(b) Similarly, internal planning is prepared for controlling the wastage of labour time and other general overheads.

(c) Internal planning for risk is also known as “Self-insurance.”

2. External Planning for Reducing Risk:

This type of risk is also known as “Risk Shifting” Here a firm takes the help of any external source to reduce business risk.

For example:

We can say that the best example of external planning is the insurance against the risk of flood, fire, theft, robbery etc. A firm takes the help of insurance company to reduce the risk of industrial accidents. Similarly, the Employees Compensation Act of 1923 provides that if an employee is injured while working in an enterprise or dies due to any industrial accident, a certain compensation will be paid to him.

Generally firms take the help of insurance company in reducing the various risks of the company.

Popular Technique to Evaluate Risk or Risk-Evaluation Approaches:

Risk-Evaluation Approaches as suggested by eminent management authors are four and they are as follows:

1. RAD – Risk Adjusted Discount Rate Approach:

This is one of the simplest and most widely used methods for incorporating risk into the capital budgeting decision. Under this method the amount of risk inherent in a project is incorporated in the discount rate employed in the present value calculations. The relatively risky projects would have relatively high discount rates and relatively safe projects would have relatively low discount rates.

For example:

A very low RAD-if we intend to purchase a risk-free asset such as “Treasury bills”. On the other-hand a much higher RAD would be used if we intend “to invest in a New Project”, which introduces a new-product into the untried market. In practice—different RAD for different types of project are charged.

Normally 10% is charged for projects involving expansion program­mes; 15% for new project and 20% for introducing a new product to new type of customers.

2. CEA – (Certainty Equivalent Approach):

This approach is an alternative to the risk adjusted rate method i.e., (the first method) to incorporate risk in evaluating investment project. This method eliminates the problem arising out of the inclusion of risk-premium in the discounting process. This method involves the determination of the basis for modifying the cash flows to adjust for risk.

The Risk adjustment factor is expressed in terms of a certainty equivalent to co-efficient.

The certainty equivalent co-efficient represents the relationship between certain Risk. Less cash flows and risky (uncertain) cash flows. Thus, the coefficient is equal to

= Risk Less Cash Flow / Risky Cash Flow

Here, the investment decisions are associated with Risk because the future returns are uncertain in the sense that the actual returns are likely to vary from the estimates. If the return could be made certain, there would be no element of Risk.

Further, the investors would prepare a relatively smaller but certain cash flow that uncertain, though slightly larger cash flows. How much less they would accept would depend on their perception or utility preference with respect to risk.

Therefore, the use of the Certainty Equivalent Approach is to ascertain—”Riskless Cash Flows” comparable to the expected cash flows streams from the project.

3. PDA – Probability Distribution Approach:

This approach provides valuable in­formation about the ‘Expected Value of Return’ and the dispersion of the probability distribution of possible returns. On the basis of this information ‘on accept or reject’ decision can be taken. The application of this theory depends upon the behaviour of the cash flows from the point of view of behaviour cash flows being independent or dependent.

The assumption that the cash flows are independent over time signifies that the future cash flows are not affected by the cash flows in the preceding or following year.

4. DTA – Decision Trees Approach:

A “Decision Trees Approach” is a pictorial representation in tree form which indicates the magnitude, probability and inter-relationship of all possible outcomes. In this the format of the investment decision has an appearance of a tree with branches and therefore, this method is referred to as the Decision Tree Method. The decision tree shows the sequential cash flows of the proposed project under different circumstances.

Merits or Advantages:

The important advantages of this approach are as follows:

(1) This is an useful alternative for evaluating risky investment proposals.

(2) This method takes into account the impact of all probabilistic estimates of potential outcome?

(3) The decision trees approach is especially useful for situations in which decisions at one point in time also affect the decisions of the firm at some later date.

(4) This approach is useful for such projects which require decisions to be made in sequential parts.