Risk-Adjusted Discount Rate Approach

Risk-adjusted discount rate approach (written as RAD or RADR approach) is based on adjusting the discount rate to reflect project risk in computing present values. The more risky the project, the higher the discount rate; less risky, or safer, the project, lower the discount rate. This is reflected in a low RAD for risk-free assets such as treasury bills. Lease-purchase capital budgeting involves almost no risk (since no variability is associated with the returns) and interest rate for this is low. If transport trucks are funded even as they operate in unsafe areas, the interest rates charged are high. Cost-reduction projects may have RAD of, say lo%, income-expansion projects, say 12%, new projects in unfamiliar surroundings, say 18 to 258, and so on. The risk-adjusted discount rate expresses the combined time-and-risk preference of the investors. The difference between the two rates is called the risk premium. 

It is generally believed that RAD rate must increase monotonically from the risk-less, or risk-free, rate of return at risk described by zero magnitude of coefficient of variation [CV, more fully described under Method 2 (ii) hereinafter] to higher values as CV increases. 

RAD rate is employed in evaluating the NPV of any risky project (in place of the risk-free rate). Acceptance and ranking depend on the positive magnitude of the NPV. 

If IRR is used as the decision criterion, the IRR derived is to be compared with the risk-adjusted required rate of return. If IRR > RADR, the project is acceptable; and ranking is by the difference (IRR - RADR). 

If any particular future year's cash inflow is more risky than in other years, a still higher RAD rate may be applied to that particular year's cash inflow; correspondingly, a lesser RAD rate for a less risky future year's cash flow. 

The one important criticism on this method, is that it adjusts the wrong element. It is the future cash income that is subject to risk; rather than adjusting the cash flow for the risk in it, the method adjusts the rate of return to be applied. 

Another important criticism is that by adding the risk premium to the discount rate, the method leads to severely compounding the risk over time; i.e. the method axiomatically takes that risk increases exponentially with time (since the discounting factor goes as (1 + i)-" with n as the exponent). 

For these reasons, this is a crude method for incorporating risk into capital budgeting analysis and decisions.