RAROC
RAROC (Risk Adjusted Return On Capital) is a risk-based financial performance measure that companies use to evaluate the profitability of their operations. It is calculated by dividing the return on capital (ROC) by the amount of risk taken (RAR). RAROC helps measure the economic performance of an organization, taking into consideration the level of risk taken and the return achieved.
RAROC is expressed as a percentage and is calculated by dividing the Return on Risk-Adjusted Capital (RORAC) by the Total Risk-Adjusted Capital (TRAC).
Example of RAROC
Let’s assume a company has invested $1,000,000 in a project and the return on capital (ROC) for the project is $150,000. The total risk-adjusted capital (TRAC) for the project is $1,200,000. The return on risk-adjusted capital (RORAC) for the project is $180,000. In this case, the RAROC for the project would be:
So, the RAROC for the project is 15%.
In summary, RAROC is an important measure of financial performance and can be calculated by dividing the return on risk-adjusted capital by the total risk-adjusted capital. In the example given, the RAROC was 15%.
Formula of RAROC
Where:
- RORAC stands for Return on Risk-Adjusted Capital and is the total return on all capital investments adjusted to reflect the risks associated with those investments.
- TRAC stands for Total Risk-Adjusted Capital and is the amount of capital invested adjusted to reflect the risks associated with those investments.
When to use RAROC
RAROC can be used to evaluate a variety of investments, such as new products, projects, or business lines. It can also be used to compare the performance of different investments and to evaluate the performance of the organization as a whole. Additionally, RAROC can be used to assess the risk-adjusted return of a portfolio of investments.
Types of RAROC
RAROC can be divided into three main categories:
- Expected RAROC is the expected return on the capital investment when taking into consideration the risks associated with the investment.
- Potential RAROC is the maximum return that could be achieved on the capital investment when taking into consideration the risks associated with the investment.
- Actual RAROC is the actual return achieved on the capital investment when taking into consideration the risks associated with the investment.
Steps of RAROC
RAROC is a process that involves three steps:
- Estimate Risk: The first step is to estimate the amount and type of risk associated with each capital investment. This includes assessing the potential for losses, volatility and other factors.
- Assess Return: The second step is to assess the return on each capital investment. This includes evaluating the expected return, the cost of capital, and other factors.
- Calculate RAROC: The third step is to calculate the RAROC by dividing the return on capital by the amount of risk taken. This is done by multiplying the return on capital by the risk-adjusted capital and then dividing it by the total risk-adjusted capital.
Advantages of RAROC
- RAROC helps organizations accurately measure their performance by taking into consideration the level of risk taken and the return achieved.
- It is a more precise measure than other performance measures, such as ROI, as it takes into account the risk associated with the investments.
- RAROC helps identify areas of inefficient capital allocation and allows organizations to make better, more informed decisions regarding their investments.
Limitations of RAROC
RAROC is a useful tool for measuring financial performance, but there are some limitations. RAROC does not take into account the liquidity of assets or the time value of money. Additionally, RAROC does not consider the impact of external factors such as macroeconomic conditions, government policies, and market volatility.
Finally, RAROC does not incorporate qualitative factors such as management expertise or the ability to manage risk.
There are other approaches related to RAROC that can help companies measure the performance of their operations. These include:
- Economic Value Added (EVA): This is a measure of a company's financial performance based on the difference between the return on its invested capital and its cost of capital.
- Economic Profit (EP): This is a measure of a company's financial performance based on its net income minus its cost of capital.
- Return on Capital Employed (ROCE): This is a measure of a company's financial performance based on its operating profit divided by its capital employed.
In conclusion, RAROC is a risk-based measure of financial performance that helps companies measure their economic performance. Other approaches related to RAROC include EVA, EP and ROCE, which are measures of a company's financial performance based on different metrics.
RAROC — recommended articles |
Return on equity (ROE) — Profitability index — Unlevered beta — Return on investment — Annualized rate — Beta risk — Accounting rate of return — Investment ratio — Distributable profit |
References
- Stoughton, N. M., & Zechner, J. (2007). Optimal capital allocation using Raroc™ and Eva®. Journal of Financial Intermediation, 16(3), 312-342.
- James, C. M. (1996). Raroc based capital budgeting and performance evaluation: a case study of bank capital allocation.