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Sovereign Risk Monetary value as expressed in a currency will always carry with it a risk component related to the political certainty of the issuing country, especially where there is the possibility of currency degradation, political turmoil, change of Government priorities, nationalisation, privatisation and re

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Bank Risk In the current economic and financial environment, bank risk is very real and very difficult to accurately assess. The recent collapse of the Barings bank as a result of unauthorised trading is a clear example. Bank risk can also be expressed as the difference in margins between secured government debt and bank debt.

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Corporate Risk The corporate credit rating will help determine a company's risk profile. By way of a very specific example, corporate risk could be isolated by identifying the margin on returns from bank investments versus corporate debentures. Where debentures are available, these are typically issued at a higher rate than bank investments.

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Project Risk The Corporate Risk component carries with it the risk value of all the activities of the business. Certain projects have special risk factors above or below the average level of risk: eg. an oil company planning to drill in difficult or uncommon terrain.

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Profit Margin Once you have accounted for Project Risk you have reached a rate which equals the Internal Rate of Return (the 'breakeven' point). Here, the cash flows have been discounted for time value and risk to a net zero pound value, such that the Net Present Value of the project is exactly zero. Of course, we need more than a zero (risk weighted) return. A profit margin can be added to the discount rate to reflect our need for a reasonable return on the project. The same result could also be achieved by using the Net Present Value amount as a decision filter.

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Scarcity Margin Unfortunately, not all organisations have excess capital and often the capital budgeting process can function more as capital rationing. Here, we have to apply a scarcity margin to our discount rate to eliminate from selection the lower returning projects.
Assuming that our DCF calculation and assumptions are accurate then the scarcity margin represents lost future profits (Opportunity Costs). The Capital Scarcity Loss is likely to be greatest in difficult economic times where prices are depressed and current investment can yield steep future returns. 
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the Risk Free Rate, which simply represents the preference for 'now', but with no risk

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the Official Rate, which reflects both the preference for now plus the sovereign risk of the country. These rates are the official interest rates

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the Bank Savings Rate, which adds in the bank risk factor

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the Cost of Funds, which is the rate the company pays on its borrowings after its risk margin (over the bank) is added in

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the Internal Rate of Return, which is the point where the project risk is balanced against the project returns and the Net Present Value of the project is therefore exactly zero

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the Optimal Discount Rate, which represents the ideal rate to evaluate projects given risk adjustments and profit needs

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the Rationing Discount Rate, which effectively overrides all the notional components of the discount rate by functioning as a rationing tool where investment funds are scarce.
