RISK ADJUSTED DISCOUNT RATE METHODPresented by : Vineeth. K

Risk Risk exists because of the inability of the

decision-maker to make perfect forecasts. In formal terms, the risk associated with an investment may be defined as the variability that is likely to occur in the future returns from the investment. Three broad categories of the events influencing the investment forecasts: General economic conditions Industry factors Company factors

METHODS OF INCORPORATING RISK The methods of incorporating risk into capital

budgeting analysis can be broadly categorised as follow:

RISK ADJUSTED DISCOUNT RATE METHOD The use of risk adjusted discount rate is based on

the concept that investors demands higher returns from the risky projects. The required rate of return on any investment should include: compensation for delaying consumption equal to risk free rate of

return, plus compensation for any kind of risk taken on.

If risk associated with any investment project is

higher than risk involved in a similar kind of project, Risk-adjusted rate is rate, will allow upward in order to risk discount discount adjusted for both time preference and preference and will be a sum of the risk-free rate and the risk-premium rate compensate this additional risk borne. reflecting the investors attitude towards risk.

Adjusting discount rate to reflect project riskRisk If risk of project is

Discount Rate discount rate used is

greater than risk of existing investments of firm. If risk of project is equal to the risk of existing investments of firm. If risk of project is less than the risk of existing investments

higher than the average cost of capital. discount rate used is equal to the average cost of capital. discount rate used is less than the average cost of capital

Risk Adjusted Discount Rate Risk Adjusted Discount Rate for Project 'k' is given by

rk = i + n + dk Where, i - risk free rate of interest. n - adjustment for firm's normal risk.

dk - adjustment for different risk of project 'k'. rk - firm's cost of capital.

dk is positive/negative depending on how the risk of

the project under consideration compares with existing risk of firms. Adjustment for different risk of project 'k' depends on managements perception of project risk and managements attitude towards risk (risk - return

Net Present Value If the project's risk adjusted discount rate (k) is specified, the project is accepted if N.P.V. Is positive.

Example: A company engaged in manufacturing of toys is

considering a line of stationary items with an expected life of five years. From past experience the company has a conservative view in its investment in new products. Accordingly company considers the stationary items an abnormally risky project. The companys management is of view that normally required rate of return of 10% will not be sufficient and hence minimum required rate of return should be 15%. The initial investment in the project will be of Rs. 1,10,00,000 and expected free cash flows to be generated from the project is Rs. 30,00,000 for 5 years. Determine whether project should be accepted or not

Answer PV of cash inflows

= Rs. 30,00,000 x PVIAF

(15%, 5)= Rs. 30,00,000 x 3.352 = Rs. 1,00,56,000 = Initial investment PV of Cash

NPV

Inflow = 1,10,00,000 1,00,56,000 = Rs. 9,44,000 Thus project should not be accepted.

Contd.. Had the required rate of return be 10%. The position

would have been as follows. PV of Cash Inflows = Rs. 30, 00,000 x PVIAF (10%, 5) = Rs. 30, 00,000 x 3.791 = Rs. 1, 13, 73,000 NPV = Rs. 1,13,73,000 Rs. 1,10,00,000 = Rs. 3, 73,000

Risk-adjusted Discount Rate: MeritsIt is simple and can be easily understood. It has a great deal of intuitive appeal for riskaverse businessman. It incorporates an attitude (risk-aversion) towards uncertainty.

Risk-adjusted Discount Rate: Limitations There is no easy way of deriving a riskadjusted discount rate. CAPM provides a basis of calculating the risk-adjusted discount rate. It does not make any risk adjustment in the numerator for the cash flows that are forecast over the future years. It is based on the assumption that investors are risk-averse. Though it is generally true, yet there exists a category of risk seekers who do not demand premium for assuming risks; they are willing to pay a premium to take risks.