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Approaches to risk and uncertainty integration while evaluating investment projectsIn this essay results used from the MSM 6138439905 research purpose financed by Ministry of Education, Czech Republic.

Lenka Љvecovб, Hana Scholleovб, Jiшн Fotr

(VSE, Prague, CR)

Abstract

integration uncertainties investment manager

The paper is based on research and pursuit results focused on risk and uncertainty integration into investment decision making. The first part describes recourses of the research in the Czech Republic itself and other researches involved. The second part describes the faults, which are made by managers while integrating risk and uncertainty into investment decision making. These results are based on number of publications and own examination. Furthermore one can find here an investigation of the relations between the ways of risk and uncertainty integration into investment decision making and the size of the company, economic environment disposition and property.

Keywords: Investment decision making, investment projects, risk and uncertainty, risk analysis, hypotheses testing

1. Research basis

Investment decision making is one of the key fields in strategic decision making in each company, as new investment projects fundamentally affect company's future profit and prosperity. The quality of investment decision making is influenced by a larger number of factors; of which the way of respecting the risk and uncertainty can be classified as one of the most important one. This aspect was a subject of many empirical researches. The aim of the paper is to present the results of investment decision making empirical research, which was performed at VЉE, Faculty of Business Administration, Prague (Kislingerovб, 2008); and their comparison with results of other researches involved in this matter.

This empirical research was performed just before the economic and financial crisis break out in selected Czech companies (252 properly filled in questionnaires received and processed). Each questionnaire included 92 questions focused on company's economy, management and logistics. The article is focused on investment decision making process and it brings forward the results of total of three questions orientated in respecting the risk and uncertainty issues while investment projects evaluation and selection. The investigative questions and relations required are as follows:

- The question “What methods do you use to determine the size of risk and risk assessment of the investment projects?” was looking for these dependencies: expected impacts of global environment, importance of unpredictable market environment and speed of technological change for strategic decision making, existence of the strategy, the company's annual turnover, majority owner.

- The questions „How do you deal with risk when assessing and selecting the investment project?” and “What methods do you use to analyze the risk of investment project?” were looking for dependencies on the company's size and majority ownership and on the first question concerning the methods of determining the size of risk and risk assessment of investment projects.

The questionnaire's primary outcome was the absolute frequency of each answer to the particular question in the survey. The ² test of good fit was used for testing the hypothesis in the combination table. As the basis, the significance level was set at 5 % and when testing some dependencies, even gentler test was used.

Apart from the survey mentioned above there were also used the results of other researches with similar aim, which were realized in the Czech Republic, as well as in the USA, Great Britain, Finland and Sweden.

2. Defects and problems of risk and uncertainty integration into the investment decision-making process

As illustrated by the economic practice experience, a lot of bodies (different level managers as well as specialists) involved in the investment options preparation, analysis and selection, make number of failures due to inadequate respect of risk and uncertainty. The ability of these bodies to integrate risk and uncertainty appropriately into the investment decision making process is determined not only by their qualifications and experience but also by analytical abilities to acquire and process the information.

In completely ideal environment the managers could make rational decisions but real life is different; there are many barriers of rationality. These barriers can be both on manager's part (in particular lack of knowledge, abilities and skills) or they are arising in connection with the environment, where managers exist (e.g. time pressure, lack of resources - financial, human and other, inadequate access to information, etc.).

Among the fundamental weaknesses of investment decision making (as well as strategic decision making in general) uncertainty ignorance is very frequent. This is usually reflected as binary understanding of uncertainty, i.e. managers assume either full certainty or complete uncertainty in business environment development.

The binary understanding of uncertainty, as mentioned above, originates in knowledge of McKinsey consulting company's experts (see Courtney, Kirkland, Viguerie, 1997). Whereas neglecting the uncertainty associated with presumption of sufficiently reliable forecasts in business environment development, is, according to these authors, eligible only in 30 up to 40% of problems of strategic decision making. Complete uncertainty concerns not more than 10% of these problems. The uncertainty has, in more than 50%, either discrete nature and can be described by number of so-called real scenarios (risk factors have binary character, where it can be for example acceptance or nonacceptance of certain regulatory or legislative measures, etc.); or joined nature (e.g. purchase and sales price trend, exchange rate, etc.).

In the first scenario - full certainty presumption, the managers believe that the development of business environment is stable enough and it is possible to define sufficiently accurate forecasts of key risk factors development, which significantly influence the result of the investment. The foundation for investment decision making is the most likely scenario, either in terms of the key risk factor estimated forecast, or development combination of several most important risk factors. With this approach the uncertainty is ignored, which means the investment decision making with full certainty instead of investment decision making with risk of uncertainty. Such simplification can be eligible in some cases (with sufficiently stable business environment) as it enables and considerably simplifies the entire decision making process, because creating investment financing plans with one scenario is relatively easy. Unfortunately, such simplification is, in many cases, completely inadequate and has negative impact on quality of the investment decision making process. Often then happens that the actual development differs from the only (the most likely) considered scenario and accomplished results are significantly different from those anticipated. Especially in case of adverse deviations in the investment decision making with irreversible nature (for example construction of new dedicated units) such unjustified simplification may even lead to bankruptcy. Uncertainty ignorance also results in less prepared organisation to utilize future opportunities and protect against other risks.

As already mentioned above, the counterpart of full certainty presumption is complete uncertainty presumption that is often equally inadequate. It is clear, that in case of completely uncertain development of business environment any prognosis is extremely difficult and uncertain, key risk factors may not be known, let alone their possible trend and impacts. In this case managers make either intuitiveThe role of intuition while making strategic investment decisions is significant. It often helps to bridge high uncertainty, which would otherwise fail any clearly defined methods. However, it is appropriate to combine both methods (the intuitive as well as clearly defined ones) and to support the intuitive solution by quantitative tools and methods (Fotr, Љvecovб et al., 2010). decisions, or in case of considerable aversion to risk they rather avoid critical decisions and direct their attention to partial measures, which are, in terms of risk, rather neutral; e.g. cost reduction, employee satisfaction increase etc. Overrated risk rate then also becomes a buck-passing while justifying failure of chosen investment decision.

Between other weaknesses in work with risks and uncertainty of investment decision making in context of manager's limited capabilities to process information and limited scope of their detection can be included:

- Searching for information confirming present findings and denying information that are contrary to these findings.

- This also bears relation to inadequate importance given to the first information available (estimates are then made on the basis of these primary information), e.g. investment decision making according to historical figures (respectively the current state).

- Overestimating the precision of judgement and forecast and undervaluation the very likely circumstances (both negative as well as positive), which are not based on this trend.

- Overestimating the unlikely negative circumstances (super caution), especially if it is dependent on personal experience, and related avoiding risky decisions, when manager tries to postpone making such decisions due to apprehension of adverse impactsIt is often associated with inappropriately created companies' motivation system, when managers are “punished” for making decisions leading to adverse results but they aren't “punished” for letting slip an opportunity..

- On the other hand succumbing the excessive optimism that is based on presumption of quite promising business environment affecting the results of investment alternatives. This leads to a situation, when the most likely scenario applied is optimistically deviated, e.g. overestimating investment projects' earnings, which is associated with underestimating costs of these projects (Fotr, Souиek, 2005).

- Ignorance of risk factors or defining too narrow intervals of their uncertainty, when, for example extreme trends and step changes in the environment are not taken into account. Often there are accepted only such changes of current environment that oscillate around the current status or most likely development (which can lead to both exposure to risk as well as ignorance of attractive opportunities).

- Disrespecting the dependence of attention devoted to risk factors upon the nature of environment, which the company belongs to (the more uncertain environment, the more attention to external factors should be paid). However, managers rather deal with such risk factors that do not require demanding analysis, i.e. mostly internal factors.

- Lower-level managers are not reflecting the top managers' (senior management's) attitude to risk. Lower-level managers then, without appropriate leadership and stimulation, either expose company to too much risk or act hyper-conservatively and do not use such desirable risk behaviour to make the best of an attractive opportunity.

- When looking for possible solutions of problems with making decisions, these are overly based on already known solutions and the alternatives found are often close to each other.

- Repetition of wrong (inefficient) decisions that is motivated especially by denying the acknowledgement of mistakes from the past. For example, according to Fotr and Љvecovб (2010), there is so called trap of buried costs arising, when the amount of buried costs becomes one of the assessment criteria.

The list of deficiencies of work with risk and uncertainty mentioned above is not surely complete. It is also noteworthy to mention neglecting the formation and usage of well-timed warning systems, which support quick identification of risks and opportunities from their first signals. The existence of such systems significantly contributes to increase of quality of risk and uncertainty integration into strategic decision making.

The deficiencies of work with risk and uncertainty mentioned above are resulting from number of surveys implemented in the Czech Republic, see Љvecovб (2005), Fuтkovб (2006), Dudek (2003), Fotr (1983), as well as in other countries, e.g. Courtney, Kirkland, Viguerie (1997), Hammond, Keeney, Raiffa (1999), Hбjek, Hynek, Janeиek, Lefley, Wharton (2001).

3. The findings and conclusions of surveys regarding the applied procedures and tools while determining the size of risk of investment projects and their evaluation

3.1. Ways of determining the investment projects' risk size, respectively its evaluation

One of the key aspects how to evaluate quality of risk and uncertainty integration is how enterprises define just the size of such risk while evaluating investments projects risks. It was examined if (see Table 1):

A1: they carry out verbal characteristics (e.g. insignificant, small, medium, high, unacceptable risk),

A2: they carry out numeral characteristics (e.g. probability of loss, variance, standard criteria deviation such as profit, net present value etc.),

A3: the risk is being neglected,

A4: they apply other methods to define the risk size, respectively to evaluate investments projects risks.

In accordance with the expectations, when defining the risk, most of queried enterprises do not carry out numeral characteristics (B) but they carry out verbal characteristics (A), which are based on experience and implicit perception of risk (150 enterprises out of the total number of respondents, i.e. 60 %). It is relatively frequent (perhaps even surprising) to carry out numeral characteristics of risk (79 enterprises, i.e. 31 %) in such forms as probability of loss, variance, respectively standard criteria deviation - profit, net present value etc. Only very small percentage of companies (17 enterprises, i.e. 7 %) admitted neglecting the risk (C). However, it is reasonable to be afraid of the fact that this figure is rather underestimated and the real situation is significantly worse due to optimistic distortion caused by respondents' effort to be seen in a better light. Other 16 companies did not answer this question, so it can be assumed that more than 12% of enterprises neglect the risk. 13 enterprises, i.e. 5%, apply other methods to define the risk size of investment projects (D), whereas according to verbal answers, these are particularly verbal characteristics of risk (response type as empirical ways, estimates of qualified experts employed in the company, etc.).

Table 1. Methods of determining the size of risk of investment projects

Source: own, published in Kislingerovб aj. (2008)

In connection with this issue following hypotheses can be defined:

- Hypothesis 1: Enterprises, which, in connection with global environment changes, are expecting more opportunities and threats, will apply more sophisticated approach to determine the size of risk of investment projects.

- Hypothesis 2: Enterprises, which have more formal approach to strategic management (in terms of strategic formulation), apply more sophisticated approach to determine the size of risk of investment projects.

- Hypothesis 3: Larger companies apply more sophisticated methods of determining the size of risk of investment projects.

- Hypothesis 4: Enterprises owned by an international capital apply more sophisticated methods of determining the size of risk of investment projects.

- One would logically expect the dependence of method of determining the risk size of investment projects upon the nature of environment, which the enterprise belongs to, and upon the environment changes affecting the company observed (hypothesis 1). Whereas the greater the risk and opportunities company expects, the more attention to work with risk and uncertainty should be paid, i.e. apart from other, determining the risk size.

The dependence was examined in regard to given answers to the question „What can stated changes as well as other external global environment changes bring to your company in the near future (i.e. in approximately 5 years time)? Number of responses summarizes picture 1. below. However, the good fit test чІ did not confirm this dependence (see Table 2)It should be noted that data of companies, which did not reply to given question, were excluded from the testing in order to avoid results distortion.. The inquired dependence was not even found with reasonably reduced level of significance. It also failed to prove dependence of method of determining the investment projects' risk size upon the importance of the environment unpredictability and technological changes rate for strategic decision making.

Picture 1. Determining the risk size upon the expected environment changes affecting the company observed

Source: own, published in Kislingerovб aj. (2008)

The dependence of strategy determination method (respectively approach to strategy determination) upon the method of risk size determination of investment projects (hypothesis 2) was not proven. The dependence was examined in regard to question, whether the company has a defined strategy and if yes, in which form; with possible answers: „yes, in precise written form“, „yes, but in no precise written form“ and „the strategy is not defined“ (see Table 2).

Equally, there was not proven the dependence of the company's size (hypothesis 3) upon its ownership (hypothesis 4) on one hand and the method of determining the risk size of its investment projects on the other hand (see Table 2). In case of company's size, the dependence is demonstrable by this test only with probability of 33 % and dependence on international capital ownership is demonstrable with probability of 14 %, which is clear independence.

Table 2. Hypotheses results of the good fit test ² with 5 % significance level

Within the framework of the next question the respondents should answer how they hereafter work with the defined risk (number of responses is summarised in table 3):

B1: We neglect the risk and our evaluation (criteria calculation) is assumed on the best estimates of values (such as sales, sales and purchase prices etc.), which affect investment project results.

B2: We identify risks and discuss their possible negative impacts on project; hereafter we respect these verbally expressed impacts when evaluating and selecting investment projects.

B3: We respect the risk by reducing the financial income (profit) and by increasing financial expenses (costs) in regard to the best estimates of these values.

B4: We respect different risk size of investment projects by modifying their discount rate.

B5: We respect the risk in another way.

Table 3. Method of managing the risk when evaluating and selecting investment projects

Source: own, published in Kislingerovб aj. (2008)

The reliability of frequency of applied verbal characteristics of risk was confirmed in the previous question (methods of determining the risk size), when the same percentage of enterprises (total of 150 enterprises, i.e. 60 %) applies similar approach (in stage of evaluating and selecting investment project; identification of risks and verbal discussion of their possible negative impacts on the project).

Although these are not exactly the same enterprises, dependency of answers to both questions is very close (almost 100 % - according to the good fit test ²).

Data unreliability mentioned above, with regard to neglecting the risk in previous question, is entrenched by conclusion that 39 enterprises (16 %) truly neglect the risk (and other 16 enterprises, i.e. 6 % did not answer this question); and when determining criteria for investment projects' evaluation and selection, these are only based on the best estimates of factors, which affect figures of these values. It is rather surprising that approximately 20 % surveyed companies respect the risk by cash flows' rectification (i.e. reducing the financial income and by increasing financial expenses), which resembles the approach based on application of certainty equivalent.

It is considerably surprising that respecting the risk by modifying the discount rate has a very low frequency (only 4 %), especially provided that one sixth of surveyed companies base their criteria value determination on the best estimates of input values. This may lead to certain doubts about quality of evaluation and selection of investment projects in the group of respondents.

Even this case did not manage to prove the dependence of method how to deal with risk while evaluating and selecting investment projects upon the company's size.

3.2.1. Applied tools when analyzing risk of investment projects

There may be employed number of tools when analyzing risk of investment projects; among the best known tools are included sensitivity analysis, scenario and simulation approaches. In accordance with expectations the sensitivity analysis was among the two most frequent tools (79 companies, 31,3 %) - see Picture 2 (black stripes). Detected high frequency of scenario applications (81 companies, 32,1 %), which have mostly form of evaluated probabilistic trees, is considerably surprising though. However, these applications are in accordance with the answer to question targeted on methods of determining the risk size of investment projects, when 79 companies apply numeral characteristics. Low utilization of Monte Carlo Simulation in the field of investment decision making corresponds with expectations; in regard to demanding application of this tool and more difficult interpretation of its results. However, it is important to point out that all 77 companies (entire 30 %) do not apply any of the analysis risk tools.

Picture 2. Applied tools when analysing risk of investment projects