Risk Adjusted Discount Rate
A rate used to discount returns of high risk investments is termed risk-adjusted discount rate. This rate is used to calculate the net present value of the risky investment. The risk-adjusted discount rate calculator is an online aid in such calculation. It signifies that even though the chances of losses are higher in an investment being a high risk investment, it tends to earn a higher return.
The risk-adjusted discount rate is more appropriate for risk-averse investors who are willing to invest in a project with high risk.
Formula
The formula for calculating Risk-Adjusted Discount Rate is:
Risk-Adjusted Discount Rate = Risk-free Rate of Interest + Risk Premium
About the Risk-Adjusted Discount Rate Calculator
This calculator will provide the instant result on entering the following figures into it.
- Risk-free rate of interest
- Risk premium
Calculator
How to Calculate Using Calculator
The user simply has to insert the following data into the calculator for a quick result:
Risk-free Rate of Interest
It is the rate of interest received on investments with zero risks. Some example of risk-free investments includes treasury bills, fixed deposits, etc.
Risk Premium
The formula to calculate Risk premium (under CAPM) is:
Risk Premium = (Market Rate of Return – Risk-free Rate)*Beta
Beta is a unit to measure the risk. To know more about beta, you can refer to the following articles:
Example of Risk-Adjusted Discount Rate
Suppose a Company Micro Ltd. wants to invest in a project out of 4 options available with it. And, therefore, it is evaluating all the four options from the following details, that is, risk premium, expected cash flows, initial investments, and risk-free rate.
| Particulars | Project A | Project B | Project C | Project D |
| Risk Premium | 5% | 4% | 7% | 3% |
| Cash Flow of Y1 | 5,000 | 8,000 | 4,000 | 4,000 |
| Cash Flow of Y2 | 2,000 | 3,000 | 10,000 | 7,000 |
| Cash Flow of Y3 | 3,000 | 10,250 | 17,000 | 11,000 |
| Initial Investment | 7,500 | 20,000 | 20,250 | 17,000 |
Risk free rate of return is 2%
Now Risk Adjusted Discount Rate is:
Project A = 2% + 5% = 7%
Risk-adjusted discount rate of Project B = 2% + 4% = 6%
and, Project C = 2% + 7% = 9%
Project D = 2% + 3% = 5%
Expected Net Present Values of four projects:
(Present Value of Cash Flows less Initial Investments)
Project A = 8,868.67 – 7,500 = 1,368.67
NPV of Project B = 18,823.26 – 20,000 = -1,176.74
and, Project C = 25,213.64 – 20,250 = 4,963.64
Project D = 19,660.94 – 17,000 = 2,660.94
In the example above, Project C has the highest risk-adjusted discount rate among all the four projects and also the highest NPV.
Cautions
It is true to some extent that the risk-adjusted discount rate signifies that even though the chances of losses are higher in an investment being a high-risk investment, it tends to earn a higher return. But, the calculation of the risk-adjusted discount rate is a bit complex method. Here, it is also assumed that all the investors are risk-averse but the same is not true.
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