Question

Thoroughly answer the following questions:

Why are adjustments needed in determining risks and rates?

Answer 1

Theory Behind Risk and Return

The concept of the risk-adjusted discount rate reflects the relationship between risk and return. In theory, an investor willing to be exposed to more risk will be rewarded with potentially higher returns, since greater losses are also possible. This is shown in the risk-adjusted discount rate as the adjustment changes the discount rate based on the risk faced. The expected return on an investment is increased because there is increased risk in the project.

Reasons to Use Risk-Adjusted Discount Rate

The most common adjustment relates to uncertainty to the timing, dollar amount or duration of cash flows. For long-term projects, there is also uncertainty relating to future market conditions, profitability of the investment and inflation levels. The discount rate is adjusted for risk based on the projected liquidity of the company, as well as the risk of default from other parties. For projects overseas, currency risk and geographical risk are items to consider. A company may adjust the discount rate to reflect Investments with the potential to damage a company’s reputation, lead to a lawsuit or result in regulatory issues. Finally, the risk-adjusted discount rate is altered based on projected competition and the difficulty of retaining a competitive advantage.

Example of Discounting with Adjusted Rate

A project requiring a capital outflow of $80,000 will return a cash inflow of $100,000 in three years. A company can elect to fund a different project that will earn 5%, so this rate is used as the discount rate. The present value factor in this situation is ((1 + 5%)³), or 1.1577. Therefore, the present value of the future cash flow is ($100,000/1.1577), or $86,383.76. Because the present value of the future cash is greater than the current cash outflow, the project will result in a net cash inflow, and the project should be accepted.

However, the outcome may change as a result of adjusting the discount rate to reflect risks. Suppose this project is in a foreign country where the value of the currency is unstable and there is a higher risk of expropriation. For this reason, the discount rate is adjusted to 8%, meaning that the company believes a project with a similar risk profile will yield an 8% return. The present value interest factor is now ((1 + 8%)³), or 1.2597. Therefore, the new present value of the cash inflow is ($100,000/1.2597), or $79,383.22. When the discount rate was adjusted to reflect the extra risk of the project, it revealed that the project should not be taken because the value of the cash inflows does not exceed the cash outflow.