Risk and returns varies directly.
The concept of ‘payback period’ is used to measure risk in capital budgeting decision.
The pay back period shows in what period, the investment can be recovered. This is the
simplicity of the pay back period. It explains the period of liquidity through recovery of
capital. An investor who prepares a short term project may prefer to use the payback
period. The risk is associated with the length of the period to recover the capital. That
means long-term projects are more risky than the short-term projects.
The payback period is suited to the assessment of risks of time nature. A person who
prefers shorter term risk is ready to counter the common business risks. The uncommon
risks, strike, war, natural disaster etc., may happen or may not happen. Only if the
normal business risks go out of control or exceed the expected limits, will the investor
suffer. The limitations of the pay back period is that it will not take into the account the
time value of cash flows, lack of time pattern and it will ignore the returns after the
recovery of capital required for decision making.
- Risk-adjusted discount rate
1.1 Consider a situation where an investor invests Rs100 in Government bond
at interest rate of 6%. Now this Government bond is called risk-free bond.
If the same investor wants to invest the same Rs.100 in shares instead of in
bond, the risk factor comes into picture as far as the return on Rs.100 share
is concerned. In this situation, investor expects the returns i.e., more than
6% in the form of premium. Therefore the expected premium varies
directly with the risk. The higher the risk, the higher will be the expected
premium.1.2 To apply the risk-adjusted discount rate, following steps must be
followed:-1.2.1 Firstly, identify the discount factor based on the risk-free rate.
This will take care of time preference.1.2.2 Secondly, identify a risk-premium rate. This will take care of risk
preference.1.2.3 Thirdly, calculate the PV of Cash Flows at the discount factor
equal to risk-free rate1.2.4 Fourthly, calculate the PV of cash flows at the discount factor
equal to risk premium.