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For a long time, economic theorists have assumed that, to allow for risk,
the businessman required a premium over and above an alternative, which
was risk-free. Accordingly, the more uncertain the returns in the future, the
grater the risk and grater the premium required. Based on this reasoning, it
is proposed that the risk premium be incorporated into the capital
budgeting analysis through the discount rate. That is, if the time preference
for money is to be recognized by discounting estimated future cash flows,
at some risk free rate, to their present value, then, to allow for the riskiness,
of those future cash flows a risk premium rate may be added to risk-free
discount rate. Such a composite discount rate, called the risk-adjusted
discount rate, will allow for both time preference and risk preference and
will be a sum of the risk-free rate and risk-premium rate reflecting the
investors¶ attitude towards risk. The risk-adjusted discount rate method can
be formally expressed as follows:
The risk adjusted discount rate accounts for risk by varying the discount
rate depending on the degree of risk of investment projects. A higher rate
will be used for riskier projects and a lower rate for less risky projects. The
net present value will decrease with increasing risk adjusted rate,
indicating that the riskier a project is perceived, the less likely it will be
accepted. If the risk free rate is assumed to be 10%, some rate would be
added to it, say 5%, as compensation for the risk of the investment, and the
composite 15% rate would be used to discount the cash flows.