In the evaluation and the selection of investment proposals, the decision-maker (the finance manager) is exposed to different degrees of risks. This is extremely important in the case of Investment Property Insurance. Risk exists because of the uncertain future and the inability of the decision-maker to make an accurate forecast of future events. Several events affect the happening of future activities. Such events may be events influencing the level of business activity, events influencing all companies in an industry and events influencing only a company.
The riskiness of an investment proposal arises when there are variations in the future returns of such a proposal, and when it is difficult to make a certain and accurate estimate of the same. Uncertainty results where the future course of events is unpredictable. It is the uncertain events which give rise to the riskiness of investment proposals. In a capital budgeting decision, the concept of risk assumes vital importance.
Several techniques are available by means of which the riskiness of the investment proposals can be measured, incorporated into the proposal and thus handled in an effective manner. These techniques help in reducing the amounts of risks involved in projects and enable the decision-maker to make a fairly perfect evaluation of capital budgeting proposals.
There is the risk-adjusted discount rate technique. Under this method, a risk-adjusted discount rate is used, which is actually a composite discount rate. This risk-free rate recognizes the time preference for money, whereas the risk premium rate takes into consideration the riskiness of future cash flows. This rate accounts for risk by varying the discount rate. Accordingly, a higher rate may be used for riskier projects whereas a lower rate may be used for less risky projects. The advantages of this technique is that it is simple to understand and easy to calculate. It incorporates the risk-premium rate in the cost of capital and facilitates scientific evaluation of proposals.