LO 48.6: Compute the adjusted RAROC for a project to determine its viability.

LO 48.6: Compute the adjusted RAROC for a project to determine its viability.
RAROC should be adjusted to consider systematic risk and a consistent hurdle rate.
Adjusted RAROC = RAROC |3p (Rj^ Rp)
where: Rp = risk-free rate = hurdle rate Rm = expected return on market portfolio (3p = firms equity beta (RM Rf ) = excess return over risk-free rate to account for the nondiversifiable systematic risk of the project
Therefore, the revised business decision rules are as follows:

If adjusted RAROC > Rp, then accept the project If adjusted RAROC < Rp, then reject the project
Example: Adjusted RAROC
Suppose RAROC is 12%, the risk-free rate is 5%, the market return is 11%, and the firms equity beta is 1.5. Use ARAROC to determine whether the project should be accepted or rejected.
Answer: Adjusted RAROC RAROC (3p (R m R f ) = 0.12 -1.5(0.11 – 0.05) = 0.12 – 0.09 = 0.03
The project should be rejected because the ARAROC of 3% is less than the risk-free rate of 5%.
R i s k C a p i t a l a n d D i v e r s i f i c a t
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