Business Risk Essay

588 Words3 Pages
Section 1 – Role of Risk • Explain the term risk and discuss its importance in the investment appraisal process (10 marks) All financial decision making incorporates the future and this provides uncertainty in the midst of what will happen in any circumstance as well as terms of financial business decisions, for instance predicting the number of the roll of a dice. This term is referred to as risk and relates to the chance of loss or damage within a business. Nevertheless, risk is always followed with return and they always move together. Where there is no risk, the expected return is low (risk-free rate). The higher the risk increases, so does the return (risk premium). A minimum rate is vital to encourage an investment at all, but investors generally require an increased rate of return to compensate them for taking the risk. However, risk is always a major factor in decision making and cannot be ignored to achieve a successful outcome. In some cases, risk can be predicted with some confidence but can never be certain of the future, shifting their predictions into speculation. This is done via the investment appraisal process that includes systems such as sensitivity analysis (SA), using probabilities, expected value (EV), diversification, and utility theory. Managers and investors will use this system to predict an outcome to gain confidence • How might a company measure and the incorporate risk within its appraisal of investment opportunities? (15 marks) Companies use appraisal systems to assess the risk of investment opportunities. Sensitivity Analysis (SA) Sensitivity analysis assesses the decision on the basis of the ‘best estimate’ of each input factor in turn to result with a zero NPV for the project when all other factors are kept at their original estimated values. This provides the break-even point and the margin of safety for that
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