Looking at Risk versus Uncertainty in Corporate Finance
All businesses face risk and uncertainty, from local corner shops to major blue-chip PLCs. A key characteristic in corporate finance is managing those risks and uncertainties. Some risks and uncertainties feature more prominently in some businesses than others.
For example, a local dry-cleaner is highly unlikely to suffer a significant amount of risk from changes in the foreign exchange rates, whereas a company such as Unilever PLC with customers and suppliers all over the globe faces foreign currency risk on a daily basis.
In the world of corporate finance, the words risk and uncertainty tend to be used interchangeably, but they do have different meanings:
Risk refers to a set of circumstances that can be quantified and to which probabilities can be assigned.
Uncertainty implies that probabilities can’t be applied to a set of circumstances.
When a company is doing investment appraisal, it looks at the risk of an investment from the perspective of the business; that is, the business risk. Business risk increases depending on the expected returns. Such risk is different than financial risk, because that’s reflected in the company’s weighted average cost of capital (the average rate of return determined from all sources of finance employed by a company, which can be used as a discount rate for investment appraisal decisions).
Taken in this context, the term risk is distinct from uncertainty. But the distinction doesn’t have a significant impact in real-life business decisions, because managers are aware that they can never be completely certain about the probabilities of future events.
Risk-averse companies (those that like to avoid risk) are very concerned about the likelihood of receiving less returns than they otherwise expect, and therefore they want to assess the risk of an investment project. That isn’t to say that companies that aren’t generally risk-averse don’t want to assess the risk of an investment project, but simply that those companies are willing to take more of a gamble than a risk-averse company.