1. Investment projects in Indonesia and other emerging markets, often have low s
ID: 2738560 • Letter: 1
Question
1. Investment projects in Indonesia and other emerging markets, often have low systematic risk; this implies that appropriate projects discount rates are very low. In reality, most companies (with some notable exceptions) use very high discount rates for such projects. To explain this practice, it has stated that the investment firm uses high discount rates as an attempt to offset the effects of the optimistic estimates cash flow.
1. Is it a good idea to adjust the risk of optimistic forecasts of cash flows using changes in discount rates should be adjusted or cash flows?
Explanation / Answer
The investment projects inherently includes risk. Since investment decisions represent long-term fund commitments and long-term forecasts, they are prone to variation in future values. There are several methods by which the risk associated with unexpected variations to the cash flows can be analysed. Two such methods are risk-adjusted discount rate and certainty equivalent.
The risk-adjusted discount rate (RADR) attempts to incorporate the risk by making adjustments to the the discount rate. Average-risk projects are discounted at the firm’s corporate cost of capital, above-average-risk projects are discounted at a higher cost of capital, and below-average-risk projects are discounted at a rate below the corporate cost of capital. While Certainty equivalent (CE) method attempts to incorporate the risk by directly adjusting the values of the cash flows.Optimistic estimates of cash flows are scaled down because the riskier the flows, the lower their certainty equivalent values.
According to Alexander A. Robichek and Stewart C. Myers, "The RADR method dominates in practice because people find it far easier to estimate suitable discount rates based on current market data than to derive certainty equivalent cash flows. Some financial theorists have suggested that the certainty equivalent approach is theoretically superior, but other theorists have shown that if risk increases with time, then using a risk-adjusted discount rate is a valid procedure."
Risk-adjusted rates combine together the pure time value of money (as represented by the risk-free rate) and a risk premium. Contrarily, the CE approach keeps both the risk and the time value of money separate which gives an advantage to certainty equivalents, as combining together the time value of money and the risk premium compounds the risk premium over time due to which, the RADR method naturally assigns more risk to cash flows that occur in the distant future, and the more distant into the future, the greater is the implied risk. Since the CE method assigns risk to each cash flow specificaly, it does not incorporates any assumptions regarding the relationship between risk and time.
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