LO 48.2: Describe the RAROC (risk-adjusted return on capital) methodology and

LO 48.2: Describe the RAROC (risk-adjusted return on capital) methodology and its use in capital budgeting.
The risk-adjusted return on capital (RAROC) methodology provides users with information pertaining to the risk-adj usted performance of the firm and its business units as opposed to merely the raw performance numbers. In measuring economic performance, this methodology involves allocating risk capital to the firms business units and to specific transactions.
Benefits of RAROC include: 1. Performance measurement using economic profits instead of accounting profits.
Accounting profits include historical and arbitrary measures such as depreciation, which may be less relevant.
2. Use in computing increases in shareholder value as part of incentive compensation (e.g.,
scorecards) within the firm and its divisions. The flexibility of RAROC may also allow for deferred/contingent compensation or clawbacks for subsequent poor performance.
3. Use in portfolio management for buy and sell decisions and use in capital management in estimating the incremental value-added through a new investment or discontinuing an existing investment.
4. Using risk-based pricing, which will allow proper pricing that takes into account the
economic risks undertaken by a firm in a given transaction. Each transaction must consider the expected loss and the cost of economic capital allocated. Many firms use the marginal economic capital requirement portion of the RAROC equation for the purposes of pricing and determining incremental shareholder value.

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