For a long time, economic theorists have assumed that, to permit for risk, the businessman necessary a premium over and above an option, which was zero cost. Accordingly, the far more uncertain the returns in the future, the grater that and grater the premium necessary. Based on this reasoning, it is proposed that the premium be incorporated into the capital budgeting analysis through the discount rate. That is, if the time preference for dollars is to be recognized by discounting estimated future cash flows, at some risk free of charge rate, to their present value, then, to permit for the riskiness, of those future money flows a risk premium rate might possibly be added to risk-free discount rate. Such a composite discount rate, named the risk-adjusted discount rate, will permit for both time preference and preference and will be a sum of the risk-free of charge rate and risk-premium rate reflecting the investors' attitude towards of that. The adjusted discount rate technique can be formally expressed as follows:
Risk-adjusted rate = Risk no cost rate + Risk premium
Under capital asset pricing model, the premium is the distinction between the industry rate of return and the risk free of charge rate multiplied by the beta of the project.
The risk adjusted discount rate accounts for that by varying the rate depending on the degree of risk of investment projects. A higher rate will be put to use for riskier projects and a lower rate for much less risky projects. The net present value will decrease with escalating adjusted rate, indicating that the riskier a project is perceived, the less most likely it will be accepted. If the totally free rate is assumed to be 10%, some rate would be added to it, say 5%, as compensation for the risk of the investment, and the composite 15% rate would be employed to discount the cash flows.
Positive aspects of adjusted rate
• It is hassle-free and can be without difficulty understood.
• It has a amazing deal of intuitive appeal for risk-averse businessman.
• It incorporates an attitude towards uncertainty.
Disadvantages
This method, yet, suffers from the following limitations:
• There is no simple and easy way deriving a adjusted rate. Capital asset pricing model delivers a basis of calculating the adjusted discount rate. Its use has however to pick up in practice.
• It does not make any adjusted in the numerator for the money flows that are forecast over the future years.
• It is based on the assumption that investor are risk-averse. By means of it is commonly accurate, there exists a category of seekers who do not demand premium for assuming risks they are willing to pay premium to take risks. Accordingly, the composite discount rate would be reduced, not elevated, as the level of increases.
