Risk-Adjusted Discount Rate
An estimation of the present value of cash for high risk investments is known as risk-adjusted discount rate. A very common example of risky investment is the real estate. Risk adjusted discount rate is representing required periodical returns by investors for pulling funds to the specific property. It is generally calculated as a sum of risk free rate and risk premium. The variation of risk premium is depending on the risk aversion of investor and the perception of investor about the size of property’s investment risk.
Risk-adjusted discount rate = Risk free rate + Risk premium
Under CAPM or capital asset pricing model
Risk premium= (Market rate of return - Risk free rate) x beta of the project
The risk-adjusted discount rates declare for that by altering the rate depending on possibility of risks of investment projects. For higher risk investment project a higher rate will be used and for a lower risk investment project, a low rate will be used. The net present value is inversely proportional to risk-adjusted discount rate as an increase in adjusted rate will decrease net present value, representing that the task is less acceptable and perceived as riskier one. A rate which would be used to discount the cash flow is the sum of risk free rate and compensation for investment risk. Suppose risk free rate is 10% and compensation of investment risk is 5%, then a rate of 15% will be use for discount cash flow.
Plus points of adjusted rate
- It is quite simple and easy to understand.
- Risk adjusted rate has a good deal of intuitive appeal in the eyes of risk averse business person.
- It integrates an attitude towards uncertainty.
Limitations of adjusted rate
- There is no easy way of obtaining an adjusted rate. Capital asset pricing model offers a basis of computing the risk adjusted rate. Its use has still to pickup n practice.
- It is completely relay on the assumption that investors are risk averse. Through it is mostly true; however, a group of seekers also exists who never demand premium for risk assumption. They willingly paying premium to take risks. Accordingly, with the level of increase, discount rate will decrease.