RISK EVALUATION APPROACHES
Once the nature of risk is understood and its quantum estimated, it is to be incorporated within the decision making framework. This section examines the popular techniques to handle risk. They are:
1. Risk-adjusted Discount Rate Approach
2. Certainty-Equivalent Approach
3. Probability Distribution Approach
4. Decision-tree Approach.
Risk-adjusted Discount Rate Approach
‘The Risk-adjusted Discount Rate (RAD) Approach is one of the simplest and the most widely methods for incorporating risk into the capital budgeting decision. Under this method, the a of risk inherent in a project is incorporated in the discount rate employed in the present value calculations. Relatively risky projects would have relatively high discount rates and relatively projects would have lower discount rates. For example, we would use low we=intend to purchase a risk-free asset such as treasury bills. On the other hand, a much higher RAD would be used if we intend to invest in a new project which introduces a new product an untried market. In fact, in practice, the companies may he using different RADs for different types pf projects. For instance, RAD may be, say, 10 per cent for projects involving expensive programmes, 15 per cent for new projects and a still higher rate, say, 20 per cent if the projects concerned with introducing a new product to new types of customers.
The risk adjusted discount rates presumably represent the differential risk in different classes of investments. The rationale for using different RADs for different projects is as follows. The rate of discount or the cost of capital (k) is the minimum acceptable required rate of return. It is the rate which the investors demand in providing capital to the firm for an investment having a specified risk since such rate is available elsewhere in the economy on assets of similar risk. Therefore, if the project earns less than the rates earned in the economy for that risk, the shareholders will be earning less than the prevailing rate for that risk level, and the market value of the company’s shares will fall. The cost of capital, therefore, represents the investors time preference for money for a typical investment project. Thus, the cost of capital is equivalent to the prevailing rate in the market on that risk class of investment. A well accepted economic premise is that the required rate of return should increase as risk increases. Therefore, the greater the riskiness of the project, the greater should he the discount rate and vice versa. The risk adjusted discount rate is the discount rate which combines time as well as risk preference of investors.
The use of a single rate of discount without considering the differing risk of various projects would be logically inconsistent with the firm’s goal of shareholders wealth maximization. Figure portrays the relationship between the amount of risk and the required k. It indicates that cash flows of project X with no risk will be discounted at the lowest rate (6 per cent). But is the risk (measured in terms of coefficient of variation) increases, the cash flows of other Projects (Y, Z and W) have to be discounted at progressively higher rates, viz. 10 per cent. 14 per cent and 18 per cents respectively.