Posted in Finance, Accounting and Economics Terms, Total Reads: 450
Definition: Return on Risk-Adjusted Capital
This simply refers to the returns to risk adjusted capital ratio. This signifies that simply calculating the rate of return on equity or the rate of return on capital employed might not be useful as we compare different types of projects with different capital structures and different risks associated like corporate finance or project finance.
Using Return on Risk Adjusted Capital, we can calculate the rate of return based on the capital at risk. There are various different ways to calculate the capital at risk. Calculation of RORAC:
Return on Risk Adjusted Capital (RORAC) = Net Income/ Allocated Risk Capital
Based on the risks associated with the project there are different risk weights associated to be used while calculating the capital at risk. Allocated risk capital is also referred to as the firm’s capital which is adjusted for the maximum potential loss based on the profitability of future cash flows or volatility of future earnings.
The importance of this concept lies in the area on Financial Risk Management. This is the heart of regulatory bodies and the concept of risk weights and value at risk first started in BASEL I norms. Basically, they talk about how different projects have different risks and associated credibility and hence different risk weights should be associated with them while calculating value at risk. Further, the value at risk is used for the calculation of minimum capital requirements of the banks and the associated base lending rates for various projects.