Define Risk Adjusted Discount Rate and Certainty Equivalent Technique.

Risk Adjusted Discount Rate ("RADR") and Certainty Equivalent Technique are measures of risk evaluation Risk Adjusted Discount Rate: RADR is the discount rate applicable to a risky investment and is the sum of the risk-free rate and a risk premium relating to that investment. RADR is also known as Varying Discount Rate Method. Under this method discount is adjusted in accordance with the degree of risk. RADR = Risk Free Rate of Return + Risk Premium Rate This is a simplest method of accounting for risk in capital budgeting is to increase the cut-off rate or the discount factor by certain percentage on account of risk. The projects which are more risky and which have greater variability in expected returns should be discounted at a higher rate as compared to the projects which are less risky and are expected to have lesser variability in returns. Certainty equivalent technique. In this method, cash flows are corrected and reduced to conservative levels by multiplying them by certainty equivalent co-efficient (or correlation factor). Certainty Equivalent Co-efficient = Riskless Cash Flows / Risky Cash Flows This is another simple method of accounting for risk in capital budgeting. This reduces expected cash flows by certain amounts. It can be employed by multiplying expected cash flows by certainty equivalent co-efficient as to convert the uncertain cash flows to certain cash flows.