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Establishing risk thresholds for any business endeavour is essential. Organizations that can quantify risk have better insights on risk management
Governance authorities argue that one of management's major responsibilities is risk management. Risk management includes identifying the sources of risk, choosing the appropriate level of risk, and monitoring actual risk levels to identify situations in which the chosen risk levels might, or have been, breached. Evidence has shown that the straightforward failure to identify, manage and monitor risks can reduce shareholder value, hinder organizations from meeting business objectives, and lead to significant financial losses or business failure. Risk management plays an integral part in making certain such problems don't occur.
This article focuses on identifying, describing, and quantifying the risk associated with capital investments. As the risk profile becomes more complicated, it is necessary to use modelling tools to assist in decision making. However, having the proper inputs for such models are a critical part of making the process a useful and effective one.
Risk and uncertainty
In 1921 Frank Knight, in a seminal book Risk, Uncertainty and Profit, defined risk as a situation where decision makers can assign statistical probabilities to the randomness that they face, and defined uncertainty as situations in which they cannot. More recently there has been a trend to define uncertainty as randomness in the events or circumstances that can affect an organization's ability to achieve its objectives and risk as the potential that the organization or an important organization system will not achieve its objectives. For example, for a couple planning an outdoor summer wedding, one uncertainty is whether it will rain - risk is the potential for the weather uncertainly to disrupt the ceremony, dining, and entertainment activities. This article will use the terms uncertainty and risk in their latter meanings since they are more consistent with their implied meanings in the extant corporate governance literature.
The capital budgeting decision - a basic model case study
The management of Whistle Mines is considering developing a mine. The local government authorities have indicated that the mine could be operated for four years with no extensions. Whistle Mine's required pre-tax return on investment is 15% for investments with this risk level1. Management and staff have developed the following...