To allow a risk, businessman required a premium over and above an alternative which was risk free. Accordingly, more uncertain the returns in future, the greater the risk & greater premium required. Based on this reasoning, it is proposed that risk premium be incorporated into capital budgeting analysis through discount rate. That is, if time preference for money is to be recognised by discounting estimated future cash flows, at same risk-free rate, to their present value, than, to allow for riskiness of those future cash flows a risk premium rate may be added to risk free discount rate. Such a composite discount rate, called risk-adjusted discount rate, will allow for both time preference & risk preference & will be a sum of risk-free rate & risk-premium rate reflecting the investors attitude towards risk. The risk adjusted discount rate method can be expressed as follows:
NPV = NCFt
K= Risk-adjusted rate.
Risk-adjusted discount rate= Risk free Rate+ Risk Premium
Under CAPM risk- premium is difference between market rate of return & risk free rate multiplied by beta of the project.
The risk adjusted discount rate accounts for risk by varying discount rate depending on degree of risk of investment projects. A higher rate will be used for riskier projects & a lower rate for less risky projects. The net present value will decrease with increasing k, indicating that riskier a project is perceived, the less likely it will be accepted.
In contrast to net present value method, if firm uses IRR method, then to allow for risk of an investment project, the IRR for project should be compared with risk-adjusted minimum required rate of return. If IRR is higher than this adjusted rate, the project would be accepted, otherwise it should be rejected.
1) Simple to understand.
2) Has a great deal of intuitive appeal for risk averse businessman.
3) It incorporates an attitude towards uncertainity.
1) There is no easy way of deriving a risk-adjusted discount rate.
2) It does not make any risk adjustment is numerator for cash flows that are for cast over future years.
3) It is based on assumption that investors are risk-averse. Though it is generally true, 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. Accordingly, composite discount rate would be reduced, not increased, as the level of risk increases.
It is based on the assumption that investors are risk averse. Though it is generally true, there exists a category or risk seekers who do not demand premium for assuming risks; they are willing to pay a premium to take risk. Accordingly, the composite discount rate would be reduced, not increased, as the level of risk increases.