Introduction
Risk adjusted discount rate is a tool commonly used by management of an organization to integrate risk component when making capital budgeting decisions. It involves adding the risk premium to the provided discount rate before calculating the present value of a project. This implies that a project with low risk will have a low discount rate while a project with high risk attracts high risk adjusted rate of return.
Therefore, use of risk adjusted discount rate provides a precise value for evaluating various investment projects. The paper discusses the procedure of using risk adjusted discount rate. It also shows the relationship between risk adjusted discount rate and capital asset pricing model.
Procedures involved in using risk adjusted discount rate
The first step entails understanding the nature of the project. This requires an understanding and documentation of the processes of the project and the risk involved in the processes. The second step would entail reviewing other completed similar projects. This gives additional information about the flow of returns and partners of risk for the project.
The third step entails coming up with a risk premium that would compensate the risk assessed. The value of the risk premium ascertained is added to the risk free rate. The resulting value is the risk adjusted discount rate which is used in making capital decisions.
Relationship between risk adjusted discount rate and capital asset pricing model
As mentioned above, assessed risk is incorporated in capital decision model by adding risk premium using the capital asset pricing model. The model shows the connection between risk and return. It is based on the assumptions that the amount of return expected depends on the riskiness of the project.
Therefore, a project with high risk pays high returns. The model computes risk adjusted discount rate as a summation of risk free rate and the risk premium. The CAPM model is shown below.
Capital asset pricing model: risk-adjusted rate = risk free discount rate + risk premium*beta.
How risk classes enhance the use of risk adjusted discount rate
The discount rate or the minimum cost of capital provides the minimum required rate of return. It is the discount rate which investors will require for the capital they have injected into the firm at a particular risk level. The cost of capital tend be uniform or similar across industries. In most cases, market rate of return is the same value as the risk free discount rate.
There investors will not accept levels of returns which are less than the prevailing returns. However, it is inconsistent to use similar rate of return for all projects in a given industry. It is because various projects are exposed to different risks. The varying risks give rise to projects with different classes of risk.
Therefore, evaluation should be carried out using different discount rates for the different classes of risk. The risk free discount rate is adjusted with the risk premium for the different classes of risk. The risk adjusted discount rate will show the preferred risk adjusted rate of return for projects in the various classes of risk.
Conclusion
In conclusion, use of risk adjusted discount rate is a simple of incorporating risk element when making capital budgeting decision. Risk adjusted discount rate is a summation of risk free rate and risk premium. Capital asset pricing model is used to formulate the risk adjusted discount rate.
It adds risk free rate and risk premium to obtain risk adjusted discount rate. Further, different projects are exposed to different risks. This leads to creation of classes of projects with varying risk. Risk adjusted discount rate need to be computed for the different classes of risk.