Risk Adjusted Discount Rate Example

Suppose the Property & Casualty Insurance Company (P&C) is contemplating the purchase of one of the two database and file management software systems offered by Rockford Files, Inc. System A is specifically designed for P&C's current computer software system and cannot be used with those of other providers; system B is compatible with a broad variety of computer software systems, including P&C's and those of other software providers. The expected investment outlay is $500,000 for each alternative. Expected annual cost savings (cash inflows) over 5 years are $175,000 per year for system A and $185,000 per year for system B. The standard deviation of expected annual returns from system A is $10,000, whereas that of system B is $15,000. In view of this risk differential, P&C management has decided to evaluate system A with a 10 percent cost of capital and system B with a 15 percent cost of capital. The risk-adjusted value for each system is as follows:2

= $175,000 X I Z -1— I - $500,000 \t = 1 (1.1G)ty

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