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An appropriate risk addendum for risky projects

Pradip K. Bhaumik (International Management Institute, New Delhi, India)

Managerial Finance

ISSN: 0307-4358

Article publication date: 13 June 2016

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Abstract

Purpose

Despite many troublesome aspects in its use, the risk-adjusted discount rate has survived and continues to be extensively used by practitioners. While the appropriate discount rate for projects as risky as the current business operations of the firm can be estimated relatively easily as the firm’s cost of capital, no clear guideline is available for projects with a higher risk profile. The purpose of this paper is to evaluate an appropriate risk addendum for such risky projects.

Design/methodology/approach

Extending the framework developed by Davies et al. (2012), the perceived risk in a project is captured by focussing on a downside case scenario and estimating its probability and severity. An expression is then developed for the risk addendum (as an addendum to the firm’s cost of capital) that can be used to find the value of a risky project.

Findings

The risk addendum is found to depend only on the product of the probability (p) and the severity (d) of the downside case scenario and not on either of them individually It was also found that the risk addendum rises fast for projects with shorter lives and so is the highest for risky projects with short lives.

Practical implications

Managers can use the expression derived to evaluate an appropriate risk addendum for risky projects.

Originality/value

The paper suggests a simple framework to quantify the risk involved in a project and to evaluate an appropriate risk addendum.

Keywords

Citation

Bhaumik, P.K. (2016), "An appropriate risk addendum for risky projects", Managerial Finance, Vol. 42 No. 6, pp. 604-616. https://doi.org/10.1108/MF-06-2015-0176

Publisher

:

Emerald Group Publishing Limited

Copyright © 2016, Emerald Group Publishing Limited

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