Risk Adjusted Discount Rate - Explained
What is the Risk Adjusted Discount Rate?
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Table of ContentsWhat is the Risk-Adjusted Discount Rate?How Does a Risk-Adjusted Return Work?Factors that Necessitate a Risk-Adjusted Discount RateCorrelation of Discount Rate with Present ValueDetermining Risk-adjusted Discount Rate with a Capital Asset Pricing ModelAdvantages and Disadvantages of Using Adjusted Rates
What is the Risk-Adjusted Discount Rate?
A risk-adjusted discount rate is the rate obtained by combining an expected risk premium with the risk-free rate during the calculation of the present value of a risky investment. A risky investment is an investment such as real estate or a business venture that entails higher levels of risk. Although it is the usual convention to use the market rate as the discount rate in most applications, under certain circumstances, the application of a risk-adjusted discount rate becomes crucial.
How Does a Risk-Adjusted Return Work?
The risk-adjusted discount rate signifies the requisite return on investment, while correlating risk with return. This essentially means that an investment that is exposed to higher levels of risk also tends to bring in potentially higher returns, especially since the magnitude of potential losses is also greater. A risk-adjusted discount rate reflects such a correlation since discount rates are adjusted based on the magnitude of the risk involved.
Factors that Necessitate a Risk-Adjusted Discount Rate
Discount rates are mostly adjusted for unpredictability pertaining to the timing, value or time span of cash flows. In case of long-term projects, additional aspects such as future market conditions, inflation and profitability also need to be factored in. Companies adjust discount rates in keeping with risks associated with their projected liquidity, while also taking into account the risks associated with possible defaults by other parties. If the project is based in a foreign country, companies will also need to factor in other aspects such as currency risks and geographical risks. In case of investments that involve potential future lawsuits, regulatory issues or damage to the company's image, it is essential to adjust discount rates accordingly. Other factors that influence adjustments are projected competition and challenges to the competitive edge achieved by the companies.
Correlation of Discount Rate with Present Value
Adjusting the discount rate to account for risks also increases the discount rate itself, leading to a lower present value. This phenomenon can be best explained with the help of the following example. Two different projects, P1 and P2 both have cash flows of $1 million in a year. However, P1 involves higher risk levels than P2. Naturally, P1 will be adjusted to have a higher discount rate than P2. This will result in a lower present value calculation of P1 given its potential for raking in higher profit levels. A lower present value for P1 directly translates to a lower upfront investment required to make the exact same money as P2.
Determining Risk-adjusted Discount Rate with a Capital Asset Pricing Model
A capital asset pricing model is an instrument used to determine the risk-adjusted discount rate for a particular investment. This model adjusts the risk-free interest rate by combining it with an expected risk premium that is based on the beta of the project.
Risk-adjusted discount rate = Risk-free interest rate + Expected risk premium
The risk premium is obtained by subtracting the risk-free rate of return from the market rate of return and then multiplying the result by the beta of the project.
Risk premium = (Market rate of return - Risk free rate of return) x Beta
The beta of the project is calculated as,
Beta = (Covariance) / (Variance)
where, Covariance is a measure of the assets return relative to the return on the market, and Variance is a measure of the markets movement relative to its mean.
Advantages and Disadvantages of Using Adjusted Rates
Employing a risk-adjusted discount rate has its own set of advantages. First, such an adjustment is easy to understand and apply. Secondly, risk-adjusted rates prepare investors to face any uncertainties. Thirdly, risk-adjusted discount rates appeal to an investors institution, especially any investor that is averse to taking risks. However, a risk-adjusted discount rate is not without its limitations. To begin with, the process of obtaining an adjusted rate is not a straightforward process, especially since capital asset pricing model have limited practical applications. Secondly, such an adjustment is based on the fundamental assumption that all investors are averse to taking risks, which is not true.