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RISK ANALYSIS (C)

SELECTRION OF A PROJECT:-

Expected return can be measured as NPV or IRR or some other criterion of merit.

Variability of Return can be measured in terms of Standard Deviation or some other dispersion
index.

Given the information about expected return and variability of return, the next question is:

When a project should be accepted or rejected?

In order to answer this question three different methods can be suggested.

i) The Risk Profile Method

ii) The certainty Equivalent Method and
iii) The Risk Adjusted Discount method.

iii) The Risk Adjusted Discount method.

The risk adjusted discount method calls for adjusting the discount rate to reflect project risk.

a) If the risk of the project is equal to risk of the existing investments of the firm,
the discount rate used is the average cost of capital of the firm.
b) If the risk of the project is greater than risk of the existing investments of the
firm. , the discount rate used is higher than the average cost of capital of
the firm.
c) If the risk of the project is less than the risk of the existing investments of the
firm, the discount rate used is less than the average cost of capital of the
firm.
The Risk adjusted Discount Rate is:

rk = (i + n) + dk

where:
rk = Risk Adsjusted Discount rate of the project k
i = Risk Free Rate of Interest
n = Adjustment for the firms normal risk
dk = Adjustment for the differential risk of project k.
(i + n) = measures of the firm’s cost of capital.
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dk may be positive or negative depending on the risk of the project under

consideration compared with the existing risk of the firm.
The adjustment for the differential risk of the project k depends on management’s
perception of the project risk and management’s attitude towards risk (risk
preference).
The risk-adjusted discount rates related to the factor of risk, for different types of
investment project.
The discount rate is generally low for expansion investments and high for the new
investments.
For example:-
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Investment Category Risk-Adjusted Discount Rate
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Replacement Investment Cost of Capital
Expansion Investment Cost of Capital + 3%
Investment in Related Lines Cost of Capital + 6%
Investment in New Lines Cost of Capital + 10%
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Once the project’s risk-adjusted discount rate (rk) is specified, the project is accepted if
it’s NPV ≥ zero or any other management / consultants /experts specified value.
NPV = [At /(1 + rk)t] – I

Where:

NPVk = Net Present Value of project k.

At = Expected Cash Flow for year t

rk = Risk-Adjusted Discount Rate for project k

Despite its popularity, risk-adjusted discount rate method suffers from serious limitations:-
i) It is difficult to estimate to estimate d k consistently as it is determined in an ad
hoc and arbitrary manner.
ii) This method assumes that risk increases with time at a constant rate as this assumption may
not be valid.
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Illustration:-

The expected cash flows of a project , which involves an investment outlay of Rs 1,00,000, are
as follws:-
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Year Cash Flow (Rs)
---------------------------------------------------------------------------------------------------------------------
1 200,000
2 300,000
3 400,000
4 300,000
5 200,000
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The risk adjusted rate for this project is 18%. Is the project worthwhile?

Solution:-

We need to find out the NPV, using risk adjusted discount rate.

NPV = [At /(1 + rk)t] – I

= [A1 /(1 + rk)1] + [A2 /(1 + rk)2] + [A3 /(1 + rk)3] + [A4 /(1 + rk)4] +[A5 /(1 + rk)5] - I
= [200,000/(1 +.18)1] +[300,000/(1 +.18)2] + [400,000/(1 +.18)3] + [300,000/(1+.18)4] +
[200,000/(1 +.18)5] – 1,000,000

= - Rs 129,440

Since the NPV is negative, the project is not worthwhile.