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What is Risk-adjusted Discounted Rate Method?
When risk premium is added with risk-free rate to get the present value of a risky investment, it is called risk-adjusted discount rate (RADR). A risky investment refers to any investment that has a higher risk than normal investments. For example, high-risk investments may include real estate and other such investments.
As investors want to know the present value of risky investments, the riskadjusted discount rate is a highly efficient tool for them. Although the market rate is taken as a standard in investment return calculations, the application of riskadjusted discount rate calculations becomes instrumental in some other cases.
How Does RADR Work?
The RADR method correlates risk with return. This is done because with higher risk, the returns also tend to be higher. This is simple to understand.
An investment that has an unforeseen higher risk is also subject to unforeseen higher returns.
The RADR shows a correlation between the risk and the return to show the potential losses or profits of an investment if any.
Why is RADR an Important Tool?
It is a fact that the future is uncertain and uncertainty brings the idea of risk. For example, a long-term investment may fail due to unforeseen weather conditions. The RiskAdjusted Discount Rate method considers all the risks at once. Risks may include systematic and unsystematic risks.
In a long-term investment, there are several risks such as inflation, political risk, credit risks, and more. If a project is based in a foreign country, there is a currency risk as well. There could also be regulatory risks if the project has chances of facing potential lawsuits.
The decision of whether to invest in a project or not must be considered in the case of all projects. The above-mentioned risks must also be taken into account while considering risks altogether. Therefore, the RADR method becomes very useful for handling risks at once, offering a single-window view to investors about the potential gains or losses.
Merits of RADR Method
The RADR method has certain advantages which include the following −
It is very simple and easy to understand.
This is an appealing approach for risk-averse investors (investors who do not seek risk).
This process helps in reducing the uncertainty and fluctuations in the estimated returns.
It helps to understand the overall risk level of an investment proposal or project.
Demerits of RADR Method
The demerits of the RADR method include the following
Getting the accurate risk premium for a future event is challenging. Therefore, finding the present value of risks is also challenging.
This approach is only completely appropriate for risk-averse investors, while there may be riskseeking investors too in the market.
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