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hi, on dec 2012 question 4b, the examiner calculated the decomissioning liability by adding the cost then applying the markup and inflation. this is quite clear.
But why is the risk adjustment of 6% being compounded while the risk free rate of government and non-performance risk is being discounted?
thanks.
I don’t see the risk adjustment being compounded – it’s a one-off adjustment of 6% of 3,612. This 3,612 is itself compounded by the inflation rate of 5% to arrive at the potential end value in three years time (3,829)
To find the present value, that 3,829 must be discounted by what is the rate of risk facing the company – (effectively the company’s cost of capital) the risk free rate + the risk of the entity’s non-performance
Sorry, I think my question wasn’t clear.
What i’m trying to ask is why are the treatments for risk adjustment and the risk-free rate different?
What does it mean by risk adjustment and risk-free rate?
ThanksRisk adjustment is building into the calculations an element to try to protect against excessive exposure to unforeseeable risk
Risk free rate and the company’s own risk of non-performance, the combined total of which gives us the discount factor the use of which will give us present value, represent the reduction in the liability as a result of us assuming there is no risk together with the assumption that we shall not default in performing our obligations
Not the easiest of concepts!
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