An appropriate risk addendum for risky projects
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