R1.P1.Risk Taking

[Laura517]

Hello,

In the BT notes (document name: R1.P1. Risk Taking), Page 9 says we take risk free rate + Risk Premium as Risk adjusted discounted rate when valuing the asset, while page 24 says we WACC as Risk adjusted discounted rate.

Can someone please tell me when it is appropriate to use risk free rate + Risk Premium as Risk adjusted discounted rate ?

 

[David Harper CFA FRM]

Hi @Laura517

That's a good question. These both directly refer to the first reading (IFC). I won't lie, I think this reading, as the first reading in the syllabus, is weak tea. These are not meant to be incompatible. Rather, Risk-adjusted discount rate = Risk free rate + Risk Premium is merely a stylized (abstract) formula which, as a container, can hold many variations, including but not limited to Risk-adjusted discount rate = WACC., which implicitly is Risk-adjusted discount rate = Risk free rate + Risk premiums for equity and debt, weighted by the capital mix

The key intent of Risk-adjusted discount rate = Risk free rate + Risk Premium is merely to signify a "build=up" method; i.e., when risk is involved, we are going to add something to the risk free rate, as expected compensation for risk incurred. As a stylistic function, I personally don't see how it can be applied directly simply because it begs the question, which risk premium(s)?

To illustrate, here is CFA Level I expressing the "risk-adjusted discount rate" as a build-up, but more with more precision:
"r =Real risk-free interest rate + Inflation premium + Default risk premium + Liquidity premium + Maturity premium" (CFA Institute 257)

The common component is the risk-free base: the risk-free rate is compensation for the time value of money (if you loan me $100 for one year, if it you are 100% sure I will pay it back--it is "riskless"--you might rightfully expect compensation purely for the wait). Then under a "build up" we can add one or more premiums, but we have choices. In the case of WACC, the premiums are effectively compensation for capital invested. Thanks,

 

[Laura517]

Thank you so much David! In that case, I think, which method to use depends on the question.