440 PART 3 Long-Term Investment Decisions
RADRs in Practice
In spite of the appeal of total risk, RADRs are often used in practice.Their popu-
larity stems from two facts: (1) They are consistent with the general disposition of
financial decision makers toward rates of return,^5 and (2) they are easily esti-
mated and applied. The first reason is clearly a matter of personal preference, but
the second is based on the computational convenience and well-developed proce-
dures involved in the use of RADRs.
In practice, firms often establish a number of risk classes,with an RADR
assigned to each. Each project is then subjectively placed in the appropriate risk
class, and the corresponding RADR is used to evaluate it. This is sometimes done
on a division-by-division basis, in which case each division has its own set of risk
classes and associated RADRs, similar to those for Bennett Company in Table
10.3. The use of divisional costs of capitaland associated risk classes enables a
large multidivisional firm to incorporate differing levels of divisional risk into the
capital budgeting process and still recognize differences in the levels of individual
project risk.EXAMPLE Assume that the management of Bennett Company decided to use risk classes to
analyze projects and so placed each project in one of four risk classes according
to its perceived risk. The classes ranged from I for the lowest-risk projects to IV
for the highest-risk projects. Associated with each class was an RADR appropri-
ate to the level of risk of projects in the class, as given in Table 10.3. Bennett clas-
sified as lower-risk those projects that tend to involve routine replacement or- Recall that although NPV was the theoretically preferred evaluation technique, IRR was more popular in actual
business practice because of the general preference of businesspeople for rates of return rather than pure dollar
returns. The popularity of RADRs is therefore consistent with the preference for IRR over NPV.
TABLE 10.3 Bennett Company’s Risk Classes and RADRs
Risk-adjusted
discount rate,
Risk class Description RADRI Below-average risk:Projects with low risk. Typically involve 8%
routine replacement without renewal of existing activities.
II Average risk:Projects similar to those currently implemented. 10%a
Typically involve replacement or renewal of existing activities.
III Above-average risk:Projects with higher than normal, but 14%
not excessive, risk. Typically involve expansion of existing or
similar activities.
IV Highest risk:Projects with very high risk. Typically involve 20%
expansion into new or unfamiliar activities.
aThis RADR is actually the firm’s cost of capital, which is discussed in detail in Chapter 11. It represents
the firm’s required return on its existing portfolio of projects, which is assumed to be unchanged with
acceptance of the “average risk” project.Hint The use of risk classes
is consistent with the concept
that risk-averse investors
require a greater return for
greater risks. In order to in-
crease shareholders’ wealth—
and hence warrant accep-
tance—risky projects must
earn greater returns.