Today, the risk-adjusted-discount rates (RADR’s) are growing to be more and more popular in the contemporary business environment. In fact, this tool is often used by investors to assess and forecast possible risks associated with their investments and expected return on investments. At the same time, many specialists (French, 65) argue that this tool is not effective and it is inaccurate that makes forecasts based on the RADR’s uncertain and ineffective. Nevertheless, RADR’s allows investors to consider possible risks and count for benefits, in case the risks downturn. Anyway, the assessment and forecasting risks of investments and expected return on investments are very helpful for investors and, in spite of subjectivity of RADR’s, this method can still be applied by investors and organizations to calculate the rate of return on a risky management.
On analyzing the application of RADR’s in the contemporary business environment and its effects, it is important to place emphasis on the fact that RADR’s is one of the tools that help to assess possible return on investments and risk associated with the investments. In fact, investors are very concerned with the risks associated with their investments and expected return on investments. Naturally, each investor looks for maximization of his or her revenues through successful investments with the high return on investments. However, investors can hardly gain considerable profits investing in projects, which have low risk expectations. On the other hand, investments into projects, which are highly risky, are also unreasonable and unwanted for average investors. As a rule, investors attempt to balance their risks and expected return on investments.
At the same time, some investors attempt to increase their revenues through investing into risky projects. At any case, whether investors invest their money in a highly risky project or not, they still face certain risks because any investment is associated with risks. Risks may be higher or lower, depending on the project to invest in, but they always persist. In such a situation, investors naturally need to consider possible risks and to forecast and to calculate expected return on investments. Otherwise, they would be uninterested in investments at all. What is meant here is the fact that investors would hardly take a risk to invest in a project without calculating possible return on investments. In fact, the calculation of possible return on investments and the adequate assessment of existing risks is one of the essential conditions of taking a decision concerning investments. To put it in simple words, investors need to know what risks are and the extent to which they can occur and affect the project they invest in and what return on investment they can count for on completing the project they invest in. As a rule, this is the major condition, which investors agree to invest their money on.
At this point, it is worth mentioning the common trend to all investment projects and decision-making process, when investors have to decide whether to invest their money or not. The general trend is the higher the risk of investments is, i.e. the higher is the risk of the failure of the investment project, the higher can be return on investments. In such a context, the adequate assessment of risks and calculations of return on investments are of the outmost importance for investors are RADR’s may be quite helpful.In fact, RADR’s is calculated on the ground of the riskless rate plus a risk premium. The rate is adjusted upward as the investment becomes riskier (French, 71). In such a way, RADR’s helps to assess the present value of a risky investment. The adequate assessment of the present value of a risky investment is very important for investors because they can assess the value of the capital invested in the project and the value of the project itself. Obviously, if the present value of a risky investment is lower than the capital required for the project, i.e. the capital to be invested into the project, investors would normally refuse from such a risky investment. On the contrary, if investors understand that possible return on investments may be high and risks are worth taking, they invest into projects readily.
RADR’s may be helpful for the capital asset pricing model (CAPM). In fact, CAPM helps to reveal the relationship between the risk and expected return on investments. Investors have to be compensated in two ways: time value of money and risks (Mehrling, 75). RADR’s help investors to calculate how they can be compensated in terms of risks, whereas CAPM enhances the forecast and assessment concerning specific investment projects because CAPM allows investors to forecast and correlate actual risks associated with the investments and possible return on investments.
Obviously, risk classes affect both RADR’s and CAPM. The higher is the risk the more uncertain become investors. However, they can hardly count for high return of investments with low risks.
French, Craig W. “The Treynor Capital Asset Pricing Model,” Journal of Investment Management, 1(2), 2003, pp. 60–72.
Mehrling, Perry. Fischer Black and the Revolutionary Idea of Finance. Hoboken: John Wiley & Sons, Inc., 2005.