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Project risk refers to the potential for a project to deviate from its expected outcomes, including delays, cost overruns, or failure to achieve intended objectives. In capital investment and financing decisions, project risk specifically denotes the variability in expected cash flows and returns due to uncertain factors such as market demand, cost fluctuations, technological changes, political or regulatory shifts, and operational inefficiencies. Understanding and evaluating project risk is crucial for investors and financial managers because it directly affects the decision-making process regarding whether to undertake a project and how to finance it. Project risk can impact both the viability and the value of an investment. The higher the risk, the greater the return required by investors to compensate for the uncertainty. Therefore, assessing project risk is essential to arrive at informed capital budgeting decisions and to optimize the capital structure. Several techniques are used for measuring and evaluating project risk. These techniques can be broadly categorized into quantitative and qualitative approaches, and their applicability depends on the nature of the project and the availability of data. 1. Sensitivity Analysis This technique measures how sensitive a project’s Net Present Value (NPV) or Internal Rate of Return (IRR) is to changes in key input variables such as sales volume, price, cost of inputs, or discount rate. In this method, one variable is changed at a time while keeping others constant, to observe the effect on the project’s outcome. For example, if a 10% increase in raw material cost reduces NPV significantly, the project is highly sensitive to cost inflation. Sensitivity analysis helps identify critical variables that have the most influence on project viability and allows managers to focus on controlling these factors. 2. Scenario Analysis Scenario analysis goes a step further than sensitivity analysis by evaluating the project under different _____ ________ ________ __________ ______ __________ ________.
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