Q. Evaluate of Risk-Adjusted Discount Rate?
Illustration: - From the following date state which project is preferable:
|
Year
|
Project A
|
Project B
|
|
1
|
60000
|
60000
|
|
2
|
50000
|
60000
|
|
3
|
40000
|
50000
|
|
Initial Cost of the Project1
|
120000
|
120000
|
Riskless discount rate is 5%. Project A is fewer risky as compared to project B and therefore the management considers risk premium rates at 5% and 10% respectively as appropriate for discounting the cash inflow. The discount factors at 10% and 15% are given below
|
Year
|
10%
|
15%
|
|
1
|
0.909
|
0.876
|
|
2
|
0.826
|
0.756
|
|
3
|
0.751
|
0.650
|
Solution :-
First Step :- Computation of Risk-Adjusted Discount Rate
For Project A:
Riskless Discount Rate 5%
And Risk-Premium Rate 5%
Risk Adjusted Discount Rate 10%
For Project B:
Riskless Discount Rate 5%
And Risk-Premium Rate 10%
Risk Adjusted Discount Rate 15%
Second Step: - Computation of Discounted Cash Inflows (that is Present Value and Net Present Value of the Projects)
|
Year
|
Project A Discounted Cash Inflows at 10%
|
Project B
|
|
|
Cash Inflows (Rs)
|
Discount Factor 10%
|
Present Value (Rs.) (Cash Inflow x Discount Factor)
|
Cash Inflows (Rs)
|
Discount Factor 15%
|
Present Value (Rs.) (Cash Inflow x Discount Factor)
|
|
1
|
60000
|
.909
|
54540
|
80000
|
.876
|
70080
|
|
2
|
50000
|
.826
|
41300
|
60000
|
.756
|
45360
|
|
3
|
40000
|
.751
|
30040
|
50000
|
.650
|
32500
|
|
PV of Cash Inflow 125880 147940
Less: PV of Cash Outflow 120000 120000
Net Present Value 5880 27940
|
Comments: - The Net Present Value of Project B is superior to that of Project A. Therefore Project B is Preferable.