Risk-Adjusted Discount Rate Vs. Certainty-Equivalent Methods

To better understand the two concepts of risk-adjusted and certainty equivalent methods, let’s understand what they mean and how they are useful for investors.

What is Risk-Adjusted Discount Rate

The risk-adjusted method combines an expected risk premium with a risk-free rate to calculate the present value of an investment.

  • Risky investments include investments in real estate and other high-level risk projects. Although the market rate is considered as the discount rate, in some cases, a risk-adjusted rate for the investments becomes crucial for the investors.

  • The risk-adjusted discount rate method correlates risks and returns while signifying the requisite returns of an investment. This means that a project that is exposed to high risks also entails higher returns as the possible potential for returns are high. Such a relation is useful because returns are dependent on the magnitude of risks involved in a project.

The Certainty-Equivalent Method

The certainty-equivalent method shows an amount of investment in the future an investor will forego for a lesser amount of money now. That may happen because the future is uncertain and higher levels of risks are associated with a higher potential of losses. Therefore, risk-averse investors tend to use this method to avoid unnecessary risks in the investments.

  • The certainty-equivalent approach is usually based on the certainty of returns and hence, the probable outcome of an investment.

  • The concept of certainty-equivalent is useful in the case of ascertaining the risk tolerance of the investors.

  • It is heavily used by investors who are risk-averse and do not wish to expose their investments to higher levels of risk.

Which is Better?

The certainty-equivalent approach usually recognizes the risk in capital budgeting analysis by adjusting and calculating the estimated cash flows. It employs a risk-free rate to discount the given adjusted cash flows. Although often debated heavily, the certainty-equivalent is advantageous than the risk-adjusted discount rate method in general.

On the other hand, the risk-adjusted discount rate usually adjusts for risk by aligning the discount rate. It is therefore easy to understand that the certainty-equivalent approach is theoretically more sound technique than the risk-adjusted discount approach because it measures risk more accurately. This is so because adjusting the discount rate is far more inaccurate to calculate than adjusting the cash flows.

However, both methods are used according to their potential in finance and economics. The usability of each is different and using any one of the methods is related to its functionality to serve the purpose of calculation.