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Risk Adjusted Discount Rate (RADR) for capital budgeting

RISK ADJUSTED DISCOUNTED RATE (RADR)

Meaning of RADR:-

The discount   rates in capital budgeting represents the expected rate of return. Projects with higher risk are generally expected to provide a higher return. Conversely, projects with relatively lower risk will provide a lower rate of return. Consequently all projects should not be discounted at the same rate, namely the company’s cost of capital. Hence the cut-off discounted rate should be adjusted upwards or downward to take care of the additional (or lower) risk element. This is referred to as risk adjusted discount rate. A project will be accepted if it yields a positive NPV using the risk adjusted discount rate. Two projects with identical standard deviation can fall under two different risk grades.

Risk-range schedule:-

It is customary for companies to formulate a schedule of risk categories ranging from normal (cut-off) discount rate to say 10 to 15 percentage points over cut off rate. The initial cut off rate equals the cost of capital of the entity. As the risk grade increases, the cut off rate too goes up. Such a schedule helps executives decide the discounted rate to be used   upon the risk of the project. The following is one such table

Risk category Category Risk Range(Indicative) Discount Rate(Indicative)
         A Normal       0-10       8%
         B Normal plus       11-15      10%
         C Medium       16-20      12%
         D High       21-25      15%
         E Very high         25       20%

 

Limitations of RADR :-

RADR is simple to understand. But their computations are subjective and involve practical difficulties such as:

  • Translating the risk element into percentage terms on a consistent basis.
  • Allocation of projects into risk classes.

Not all investors are risk averse. Some may even be willing to pay a premium to assume risk , there will be no adjustment at all, in the cut off rate!

 

Method of computing RADR :-

Step 1: Identify cash flows

Step 2: Compute RADR. (RADR = Cost of Capital + Premium for risk)

Step 3: Discount the cash flows at RADR and arrive at NPV.

 

 

 

 

 

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