Posted by Kathryn Schwartz on January 24, 2014
Risk Analysis


There are a number of techniques available for analysing investment risk, which may be classified into subjective and formal techniques. Formal techniques include sensitivity analysis (SA), simulation models (SM), probability tree (PT), adjustment of required payback period (ARPP), Adjustment of discount rate (ADR) and so on. The trends in the use of formal risk analysis techniques in capital budgeting are well documented in many countries. The increasing use of formal techniques is due to the availability of computer software packages which can help in applying these techniques in practice. Among the risk analysis techniques, Sensitivity analysis technique is the most popular technique, followed by scenario analysis technique (Pike (1988 and 1996), Klammer et al (1991), Arnold and Hatzopoulos (2000), Farragher et al 1999, Farragher and Leung 1987, Kester and Chong 1998, Kester et al 1999, Jog and Srivastava 1995, Pandey 1989, Manoj Anand 2002, Ashish Kumar and Bhavin Shah 2006, ZakiOsemy 2001, for example.) The extent of use of these techniques is influenced by various factors such as organisational characteristics, individual characteristics, and industry characteristics. This study deals with select organisational characteristics viz. Environmental uncertainty and perceived company performance. Financial services

Environmental Uncertainty

This is an important variable identified from the contingency theory. This contingency framework suggests that organisations must adapt to their organisational environment in order to survive and prosper. But the present environment in which decisions are made is more complex than ever before. However, accurate understanding of the environment helps the Decision Makers make better decisions. The decision making environment is defined as the collection of all relevant information, possible alternatives, values and preferences available at the time of decision making (Robert Harris 1998). An ideal environment has all the relevant and possible information, which are accurate, and has possible and viable alternatives. However, it is impossible to have all the relevant information needed to make a decision with certainty. This indicates that most decisions involve an undeniable amount of uncertainty or risk. In the context of the contingency theory framework, many research works / researchers (Rentizeals et al 2007, Carpenter and Fredrickson 2001, Elbanna and Child 2007, Bourgeois et al 1988, Sauner-Leroy 2004, Cohen 2001, Alessandri 2003) considered environment as one of the important contingency factors. Porter (1980), Ho and Pike (1998) described environment as those forces (such as suppliers, customers, competitors, government regulatory agencies, public pressure, capital market and so forth) outside the organization, but over which the organization has little control, and that these forces can potentially affect the outcomes of a decision and in turn, organization’s performance.

Findings of the prior research studies show that the results are mixed. There is a positive relationship between environmental uncertainty and capital budgeting sophistication (Pike 1984). Conversely Kim et al (1981) found that there is a negative relationship between the environmental uncertainty and capital budgeting sophistication. From the above discussions, it is clear that there is a relationship between the environmental uncertainty and capital budgeting sophistication which indicates that DM has responsibilities to evaluate the environment and his organisation’s position before allocating resources and sometimes to move into and out of an environment. Evaluation of an environment can be done in two ways viz. Objective and perceptual. In order to measure the environmental uncertainty in automotive industry, the present study adopts perceptual measure which has been used widely. Perceived environmental uncertainty refers to “an individual’s perceived inability to predict something accurately”. In other words, perceived environmental uncertainty occur when DM perceives an organisation’s environment to be unpredictable, or an inability to understand the future state of the environment (Milliken 1987). In a given situation, it is arguable that DMs may develop diverse perceptions and interpretations when they face the ‘same’ environmental events across the country. Numerous studies (for example, Pleshko 2006, Cohen 2001, Ho and Pike 1998, Pike 1986, Namiki 1989) have used perceptual method in order to measure the environmental uncertainty in various dimensions (such as technology, competition, buyers, suppliers and so forth). From the SIDs context, it is therefore argued that decision making by the DMs have partly resulted from their ‘perception of environment’ during the decision making process. Perceived environmental uncertainty has been especially emphasised in prior studies on capital budgeting decisions. Therefore it is expected that:

H1: Higher the environmental uncertainty, higher is the level of risk analysis in SIDs Perceived Company Performance

There are number of studies which investigated the relationship between performance and risk (for example, Bromiley 1991). The past performance of a company is a major determinant of risk behaviour in decision making (Bromiley 1991) and has an influence over the design of the capital budgeting decision process (Pike, 1986). Knowing recent earning performance level helps DMs understand the present position. This, in turn, helps in making SIDs related to expansion, diversification and so forth. For example, prospect theorists (Kahneman andTversky 1979) have argued that, under conditions of adversity, failure to meet performance targets will lead to increased change and risk seeking (Bromiley 1991). This risk seeking attitude may reduce employing sophisticated techniques in their SIDs. Besides, as long as performance is at satisfactory level, companies are more likely to continue whatever rules of thumb they had followed in the past while allocating resources (Warren Boeker 1997). In simple words, the techniques employed in the past will be followed in the future when the performance of a company is at satisfactory level. Therefore it is expected that:

H2: Better the performance of a company, higher is the level of risk analysis in SIDs Proposed Research Model

This paper has conceptualised the research model with the help of the extant literature. The same is given in figure 1. The proposed relationships were examined using Partial Least Square-Path Modelling (PLS-PM).

Fig1Perceived Environmental Uncertainty-1
Figure 1: Research Model

Tags: , ,