Accounting for risks when justifying a risk premium
The methodology of the United Nations Industrial Development Organization (UNIDO) provides for the definition of a risk premium that is taken into account when forming a discount rate.
Uncertainty of the conditions for the implementation of the investment project in determining the indicators of its effectiveness can be taken into account in various ways. Depending on this, the discount rate may or may not include a risk premium. In cases where the project is evaluated under a single scenario of its implementation, the risk adjustment is included in the discount rate. The statistical and expert methods for justifying the risk premium in the discount rate are singled out.
The simplest method used in practice is to determine the discount rate expertly or based on the requirements of the investor. Based on his personal assessment of the situation on the market, the investor can determine the required profitability of the project and take it as a discount rate, which will be used in assessing the effectiveness of the project. But in order for the chosen discount rate to be adequate, a high level of investor competence is required, it must be experienced, it is good to know the market and understand it. The discount rate used in the calculations is almost always agreed with the investor or with the investment bank that attracts funds for the project. As a rule, the calculations focus on the risks of investing in similar companies and markets. The use of an expert method to justify a risk premium gives the least accurate results and can lead to a distortion of the results of evaluating the effectiveness of investment projects. In this regard, in cases where the discount rate is determined expertly or cumulatively, it is recommended that the sensitivity analysis of the project be carried out to a change in the discount rate.
Using the statistical method of assessing the risk premium when justifying the discount rate is possible based on elemental or aggregated approaches. In the elementwise approach, each type of risk is accounted for separately, with the aggregated approach, the risk adjustment is estimated to be larger for all types of risk.
Using the element-wise approach, the determination of the risk adjustment is done by factoring: identify the risk factors, determine the amount of the risk adjustment for each factor, and add corrections for each type of risk to determine the overall risk adjustment. It is recommended that the following factors should be considered first:
- the need to conduct research and development with previously unknown results by specialized research and (or) design organizations and the duration of R & D;
- the novelty of the technology used (traditional, new, different from traditional with different features and used resources, etc.);
- the degree of uncertainty in the volume of demand and the level of prices for products;
- the presence of instability (cyclicality) of demand for products;
- the presence of uncertainty of the environment during the project implementation (mining-geological, climatic and other environmental conditions, aggressiveness of the environment, etc.);
- the presence of uncertainty in the process of mastering the technology or technology used.
When determining the risk factors that will be taken into account when determining the overall risk adjustment, it is necessary to pay attention that they are independent and in the sense of risk complement each other. Otherwise, adding the amendments to the risk will lead to a double count. The Methodological Recommendations for the Evaluation of the Efficiency of Investment Projects provide an example where a risk adjustment corresponding to the need for R & D is combined with an amendment corresponding to the uncertainty of the technique or technology used. At the same time, attention is drawn to the fact that it is hardly necessary to do so, because the risk associated with the need for R & D can already include the uncertainty of the technology or technology used.
You should not enter in the discount rate an amendment to the type of risk by which the investment is insured (in this case, the insurance premium is a certain indicator of the corresponding type of risk), but when building the cash flows, it is necessary to take into account insurance payments.
Some types of risks, characterized by a statistical pattern of manifestation, can be taken into account when forming the initial economic information; in this case, their repeated accounting when justifying the correction for risk will lead to a double count.
Thus, when choosing factors whose influence is taken into account in determining the risk premium, it is necessary to check them for the possibility of double counting. If the influence of some factors is taken into account twice, the investors' demands for project efficiency will be overestimated.
There are certain limitations in applying the risk accounting method by introducing a risk premium into the discount rate. An increase in the discount rate should lead to a decrease in the net present value of the project. However, this is not true for all investment projects. For some projects, namely projects with extraordinary cash flows in which the positive and negative elements of cash flow alternate, the introduction of a risk adjustment in the discount rate can lead to an increase in net present value. As a result, taking into account the risk, the project will appear to be more effective than without risk taking. In these cases, it is recommended not to make a risk adjustment, but to take the risk into account in other ways.
It can be concluded that the risk accounting method by introducing a risk premium into the discount rate is effective for evaluating projects with positive flows throughout the life of the project. Some authors suggest using this method for projects whose cash flows take negative values not only at the beginning of the billing period. In such cases, it is suggested not to consider the risks in those periods where negative flows appear.
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