Page 191 - DMGT405_FINANCIAL%20MANAGEMENT

Unit 9: Capital Budgeting

9.7.1 Payback Notes

Payback is one of the oldest and commonly used methods for explicitly recognizing risk associated
with an investment project. Business firms using this method usually prefer short payback to
longer one and often establish policies that a firm should accept guidelines with some maximum
payback period say three to five years. Apart from simplicity, payback makes an allowance for
risk by:
1. Focusing attention on the near term future and thereby emphasizing liquidity through
early recovery of capital and
2. By favouring short-term projects over long-term riskier projects.

9.7.2 Risk Adjusted Discount Rate Approach (RAD)
Under this method, the amount of risk inherent in a project is incorporated in the discount rate
employed in the present value calculations. The relatively risky projects (e.g. project involving
introduction of new product into the untried market) would have relatively high discount rates
and relatively safe projects would have relatively low discount rates. The rationale for using
different risk adjusted rates for different projects is as follows. The rate of discount or the cost of
capital is the minimum acceptable rate of return which the investors demand in providing
capital to the firm for that type of investment since such rate is applicable elsewhere in the
economy on assets of similar risk. If the project earns less than the rates earned in the economy
for that risk, the shareholders will earn less and the value of the company’s shares will fall. A
well accepted economic premise is that the required rate of return should increase with increase
in risks. Hence, the greater the risk, the greater should be the discount rate and vice versa.

The risk-adjusted rate can be used with both the NPV and IRR methods of evaluation of capital
expenditure. If NPV were positive, the proposal would qualify for acceptance. In case of the IRR, as
a decision criterion, the internal rate of return would be compared with the risk adjusted required
rate of return and if the former exceeds the latter, the proposal would be accepted, otherwise not.
The risk in connection with future projections has two dimensions. First as already mentioned,
riskiness of the projects at a particular point of time became of the nature of proposals, e.g.,
expansion of new products. Second, the risk may be different in the case of the same project over
time e.g., risk at the end of Second year may be more than that at the end of first year.

Advantage

1. This method is simple to calculate and easy to understand, since companies in actual
practice apply different standards of discount for different projects.

Disadvantages and Difficulties

1. Difficulty encountered is how to express a higher risk in terms of higher discount rates. It
is doubtful if the exercise would give objective results.
2. It does not make direct use of the information available from the probability distribution
of expected future cash. Conceptually, this approach adjusts the wrong element. It is the
future cash flow of a project, which is subject to risk and hence should be adjusted and not
the required rate of return.
3. The process of adding the risk premium to the discount rate leads to compounding of risk
over time. In other words, this method implies increase of risk with time and therefore
proposal in which risk does not necessarily increase with the time may not be properly
evaluated by this method.

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