What Is Return on Risk-Adjusted🔯 Capital (RORAC)?

The return on risk-adjusted capital (RORAC) is a rate of return measure commonly used in financial analysis, where various projects, endeavors, and investments are evaluated based on capital at risk. Projects with different 澳洲幸运5开奖号码历史查询:risk profiles are easier to compare 🅰with each other once their individual RORAC values have been calculat💫ed.

The RORAC is similar to 澳洲幸运5开奖号码历史查询:return on equity (RO💮E), except the denomina෴tor is adjusted to account for the risk of a project.

The Formula for RORAC Is

Return on Risk-Adjusted Capital is calculated by dividing a🍸 company’s n🌞et income by the risk-weighted assets.

$\begin{aligned} &\text{Return on Risk Adjusted Capital}=\frac{\text{Net Income}}{\text{Risk-Weighted Assets}}\\ &\textbf{where:}\\ &\text{Risk-Weighted Assets = Allocated risk capital, economic}\\ &\text{capital, or value at risk}\\ \end{aligned}$​Return🌜 on Risk Ad⛎justed Capital=Risk-Weighted AssetsNet Income​where:Risk-Weighted Assets = Alloca๊ted risk capital, economiccapital, or value at risk​

What Does Re🐈turn on Risk-Adjusted Capital Tell ಌYou?

Return on risk-adjusted capital (RORAC) takes into account the capital at risk, whether it be related to a project or company division. Allocated risk capital is the firm's capital, adjusted for a maximum potential loss based on estimated future earnings distributions or the volatility of earnings.

Companies use RORAC to place greater emphasis on firm-wide risk management. For example, different corporate divisions with unique managers can use RORAC t🅠o quantify and maintain acceptable risk-exposure levels.

This calculation is similar to 澳洲幸运5开奖号码历史查询:risk-adjusted return on capital (RAROC). With RORAC, however, the capital is adjusted for risk, not the rate of return. RORAC is used when the risk varies depending on the capital asse♒t being analyzed.

Example of How to Use RORAC

Assume a firm is evaluating two projects it has engaged in over the previous year and needs to decide which one to eliminate. Project A had 澳洲幸运5开奖号码历史查询:total revenues of $100,000 and total expenses of $50,000. The total risk-weighted assets involved in the project is $400,0⛦00.

Proje𝄹ct B had total revenues of $200,000 and total expenses of $100,000. The total risk-weighted assets involved in Project B is $900,000. The RORAC of the two projects is calculated as:

 $\begin{aligned} &\text{Project A RORAC}=\frac{\$100,000-\$50,000}{\$400,000}=12.5\%\\ &\text{Project B RORAC}=\frac{\$200,000-\$100,000}{\$900,000}=11.1\%\\ \end{aligned}$​Project A RORAC=$400,000$100,000−$50,000​=12.5%Project B RORAC=$900,000$200,000−$100,000​=11.1%​

Even thoughღ Project B had twice as much revenue as Project♊ A, once the risk-weighted capital of each project is taken into account, it is clear that Project A has a better RORAC.

The Difference Between RORAC and RAROC

RORAC is similar to, and easily confused with, two other statistics. Risk-adjusted return on capital (RAROC) is usually defined as the ratio of 澳洲幸运5开奖号码历史查询:risk-adjusted return to 澳洲幸运5开奖号码历史查询:economic capital. In this calculation, instead of adjusting the risk of the capital itself, it is the risk of the return that is quantified and measured. Often, the expected return of a project is divided by 澳洲幸运5开奖号码历史查询:value at risk (VaR) to arrive at RAROC.

Another statistic similar to RORAC is the risk-adjusted return on risk-adjusted capital (RARORAC). This statistic is calculated by taking the riܫsk-adjust꧃ed return and dividing it by economic capital, adjusting for diversification benefits. It uses guidelines defined by the international risk standards covered in 澳洲幸运5开奖号码历史查询:Basel III—which is a set for reforms that are to beꦰ implemented by Jan. 1, 2022, and is meant to improve the regulation, supervision, and risk management within the banking sector.

Limitations of Using Retu𓃲rn on Risk-Adjuꦬsted Capital – RORAC

Calculating the 澳洲幸运5开奖号码历史查询:risk-adjusted capital can be cumbersome as it requ💃ires understanding the value at risk calculation.

For related insight, read more about how risk-weighted assets are calculated 澳洲幸运5开奖号码历史查询:based on capital risk.