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**Unformatted text preview: **LG3 Describe the determination and use of riskLG4
adjusted discount rates (RADRs), portfolio
effects, and the practical aspects of RADRs. The
risk of a project whose initial investment is known
with certainty is embodied in the present value of its
cash inflows, using NPV. Two opportunities to
adjust the present value of cash inflows for risk
exist—adjust the cash inflows or adjust the discount rate. Because adjusting the cash inflows is highly
subjective, adjusting discount rates is more popular.
The RADRs use a market-based adjustment of the
discount rate to calculate NPV. The RADR is
closely linked to CAPM, but because real corporate
assets are generally not traded in an efficient market, the CAPM cannot be applied directly to capital
budgeting. Instead, firms develop some CAPM-type
of relationship to link a project’s risk to its required
return, which is used as the discount rate. Often, for
convenience, firms will rely on total risk as an
approximation for relevant risk when estimating
required project returns. RADRs are commonly
used in practice, because decision makers prefer
rates of return and find them easy to estimate
and apply.
Recognize the problem caused by unequallived mutually exclusive projects and the use of
annualized net present values (ANPVs) to resolve
it. The problem in comparing unequal-lived mutually exclusive projects is that the projects do not
provide service over comparable time periods. The
annualized net present value (ANPV) approach is
the most efficient method of comparing ongoing
mutually exclusive projects that have unequal usable lives. It converts the NPV of each unequallived project into an equivalent annual amount—its
ANPV. The ANPV can be calculated using financial tables by dividing each project’s NPV by the
present value interest factor for an annuity at the
given cost of capital and project life. Alternatively,
it can be calculated using a financial calculator—
the keystrokes are identical to those used to find
the annual payment on an installment loan—...

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