Question

1. Describe the following three types of project risk. Stand alone risk, Corporate risk and Market risk. Under what situation is each of the types most relevant to the capital budgeting decision? Which type of risk is easiest to measure in practice?
2. Describe the qualitative approach to risk assessment. Why does this approach, which does not rely on numerical data, work?

Answer 1

Stand alone Risk: This kind of risk is related to an isolated project which is considered as a close project, not related with others. This kind of risk can be calculated simply by computing the standard deviation and variance of the project.

In such case coefficient of variation could be used to compare the multiple projects. The project with lower CV should be considered.

Corporate risk: It can be defined as the risk of a project that is affected by the performance and earning of the whole corporation. This kind of risk is related to the other assets of the firm.

This risk can be calculated by determining the impact of various functions of on the project.

Market Risk: Market risk is a kind of risk that does not only get affected by the corporation but also by the performance of the stock market. The performance of a project gets affected because of changes in the market scenario like change in inflation, interest rate etc.

Market risk can not be controlled. It is estimated by assigning probability to various possible events.

In general, Standalone risk is very easy to measure in practice.

Qualitative approach to risk assessment relates to the descriptive analysis of a situation rather than depending on the numerical data. This approach helps to know the likelihood of an event based upon the experience, knowledge and skills, different rating parameters etc.

Qualitative approach helps to scrutinize the project for investment since the quantitative approach is analytical and time consuming. So, once a project is passed through qualitative analysis, it should be forwarded for quantitatve analysis.