How is the risk-adjusted internal rate of return calculated?

The risk-adjusted internal rate of return (RAIRR) is a measure used to evaluate the profitability of an investment while taking into consideration the associated risks. It is calculated by adjusting the internal rate of return (IRR) of an investment for the level of risk involved.

To calculate the risk-adjusted internal rate of return, the following steps can be followed:

1. Determine the cash flows: Identify the expected cash inflows and outflows associated with the investment over its lifespan. These cash flows should include both the initial investment and any future cash flows generated by the investment.

2. Calculate the internal rate of return (IRR): Use the cash flows determined in step 1 to calculate the IRR. The IRR is the discount rate that makes the net present value (NPV) of the investment equal to zero. It represents the rate of return at which the present value of the cash inflows equals the present value of the cash outflows.

3. Assess the risk level: Evaluate the risk associated with the investment. This can be done by considering factors such as market volatility, economic conditions, industry risks, and specific project risks. Assign a risk rating or score to the investment based on this assessment.

4. Adjust the IRR for risk: Apply a risk adjustment factor to the IRR calculated in step 2. The risk adjustment factor reflects the level of risk associated with the investment. This factor can be determined based on industry standards, historical data, or expert judgment. It is typically expressed as a percentage.

5. Calculate the risk-adjusted internal rate of return: Multiply the IRR calculated in step 2 by (1 + risk adjustment factor). This will give you the risk-adjusted internal rate of return.

The risk-adjusted internal rate of return provides a more accurate measure of the profitability of an investment by considering the level of risk involved. It allows investors to compare different investment opportunities and make informed decisions based on both the potential returns and the associated risks.