Accept reject Decision
The Risk-adjusted Discount Rate Approach can be used with both the NPV and the IRR. If the NPV method is used to evaluate capital expenditure decision. NPV would be calculated using the risk-adjusted rate. If the NPV is positive the proposal would qualify for acceptance. A negative NPV would signify that the project should be rejected. In case of the IRR as a decision criterion, the internal rate of return (r) would be compared with the risk-adjusted required rate of return. If the r exceeds the risk-adjusted rate, the proposal would be accepted, otherwise not.
The risk associated with future returns has two dimensions. First, as already mentioned the degree of risk of different projects may be different at a particular point of time because of the nature of the proposals such as expansion or new products and so on. The risk may also be different in the case of the same project over time. That is to say, the return at the end of the second year may be more risky than that at the end of the first year and so on. We have illustrated below the calculations of the NPV in both types of situations.
We shall be using the following equation for the purpose of determining NPV under the RAD method.
Thus, projects are evaluated on the basis of future cash flow projections and an appropriate discount rate. Example clarifies how the K, can be used to evaluate capital budgeting projects.
Cash outlays (Rs 1,00,000)
CFAT Year 1 50,000
Year 2 60,000
Year 3 40,000
Risk-less rate of return = 6 per cent
Risk-adjusted rate of return for the current project = 20 per cent
Given the expected cash flows and estimated risk-adjusted discount rate (K), the project’s expected NPV is positive and the project should be accepted.
If the risk-adjusted discount rate is 28 per cent, the NPV will be negative (Rs 5,550). Then, the project will have to be rejected, If the riskiness of the return from the same project differs for future periods, different rates of discount for different future periods can be used. Thus, in Example it is felt that the cash no is riskier for the second and the third year compared to the first year, a higher discount rate would he used for the return in the second year than that for the first year and so on. Let the rate of discount be 20 per cent, 22 per cent and 25 per cent for the returns for the years 1, 2 and 3 respectively. Then NPV = (Rs 1,00,000) + Rs 50,000 (0.833) + Rs 60,000 (0.672) + Rs 40,000 (0.512) = Rs 2,450.