Risk-Adjusted Discount Rate (RADR) and CEQ

The RADR method is very popular and lots of companies use it in practice. In the base of method there is an idea that the high rate of risk covers the high rate of return. The formula of calculation of risk-adjusted rate is:

or

, (3.24)[19] (4.5)

– Risk-free rate or WACC

– Premium for risk each factors

The risk is estimated by the discount rate of the project because discount rate is calculated as a sum of risk-free rate or WACC and premium for risk each valuated factors. Manager has to pay attention to the fact that during the cross-border transaction some risk can be changed. For example, manager has cross-border transaction and buys the goods for gross sale in a home country. Manager makes the payment of contract in foreign currency. When manager make the payment the foreign exchange risk disappears. That is why, it would be wrong to discount the cash flow which manager have after currency payment to discount rate with foreign exchange risk.

Manager cannot hope to estimate the accurate risk of a contract, but manager has to examine any contract and look for clues to its riskiness. Also the manager has to think about the main uncertainties affecting the economy and consider how the contract is affected by these uncertainties.[20]

The financial manager could use CAPM to estimate the cost of capital and then use this figure as single discount rate for each period’s expected cash flows. The using constant discount rate for all period expecting cash flows means that contract risk does not change over time. There are two ways to value a risky cash flow of contract:

Method 1: Discount the risky cash flows of the contract at a risk-adjusted discount rate (r) that is greater than (rf). The RADR adjusts for both time and risk.

Method 2: When manager use this method hi or she have to estimate the smallest certain payoff to exchange the risky cash flow. This is called the certainty equivalent, denoted by CEQ. The CEQ is the value equivalent of safe cash flow, it is discounted at the risk-free rate. The certainty-equivalent method separates adjustments for risk and time.

(4.6)[21]

Let’s try to calculate the discount rate for my case. In my research I consider the Russian pharmaceutical export-import company, therefore I take the MIBOR.[22]as risk-free rate. I think that it is better than statement bond ГКО rates, because the MIBOR is appropriate as risk-free rate in our case. If the company wants to finance contract and borrow the money on finance market the Moscow InterBank Offered Rate would be the ideal mark or risk-free rate. The 05.03.09 the MIBOR is (18.5900), and I use the risk-free rate as (18.5900). The same is vividly seen when I take the WACC of company, as risk-free rate that is (0.1226),but Iconsider this problem late. The Beta of pharmaceutical is 0.723[23]. The r (m) is (27.83). Therefore the (r) is calculating as an opportunity cost of capital or single discount rate for our contract:

r= r (f) + ß(r (m) – r (f)) = 18.59 + 0.723(27.83 – 18.59) = 25.2705 (4.7)

And now I try to calculate with WACC as risk-free rate:

r= 12.26 + 0.723(27.83 – 12.26) = 23.5171 (4.8)

At first, I calculate NPV, IRR, and PI with discount rate, where the risk-free rate is MIBOR, therefore the discount rate is (25.2705):

	Contract I	Contract II	Contract III
NPV	227.87	228.06	243.42
PI	0.6329	0.63349	0.70559
IRR	11.35		20.36

Table 4.11

Secondly, I calculate NPV, IRR, and PI with discount rate, where the risk-free rate is WACC, therefore the discount rate is (23.5171):

	Contract I	Contract II	Contract III
NPV	228.01	228.15	243.54
PI	0.63337	0.63376	0.705904
IRR	11.35		20.36

Table 4.12