Evaluate of risk-adjusted discount rate, Financial Management

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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.


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