Risk Adjusted Discount Rate

In Entrepreneurial Finance the Risk Adjusted Discount Rate or RADR is defined as a common method of estimating Present Value. The second common method is called the Certainty Equivalent Cash Flow method. In the RADR method an expected future cash flow is convert to Present Value by applying a discount rate that represents both:

• The Time value of money
• The riskiness of the future cash flow

For a particular project $j$, that yields and uncertain cash flow at time $t$ the appropriate discount rate for valuing the expected cash flow can be stated as follows:

$r_{jt}$ $=$ $r_{Ft}+RP_{jt}$

Where: $r_{Ft}$ is the required rate of return (or cost of capital, see WACC) and $RP{jt}$ is the risk adjustment to the discount rate.

In simple terms this can be interpreted that the future cash flows are discounted faster because there is a non-neglect able risk that the future return is lower or higher than currently expected.

The present value by the risk adjusted discount rate method is given as: ${PV_{j}}=\sum _{t}{\frac {C_{j}t}{(1+r_{t})^{t}}}$