Risk-Adjusted Return On Capital (RAROC)

Risk-adjusted return on capital (RAROC) is a measure of the profitability of an investment or business, taking into account the risk involved. It is calculated by dividing the return on investment (ROI) by the risk-adjusted cost of capital (WACC).

The ROI is the net profit of an investment or business divided by the amount of capital invested. The WACC is the weighted average cost of capital, which is the cost of financing an investment or business from a combination of sources, such as debt, equity, and preferred stock.

RAROC is used to compare the profitability of different investments or businesses, and to identify those that are the most profitable. It can also be used to evaluate the performance of an investment or business over time.

RAROC is a more accurate measure of profitability than ROI because it takes into account the risk involved. For example, an investment with a high ROI may not be as profitable as an investment with a lower ROI if the higher-risk investment has a higher WACC.

RAROC is a useful tool for investors and businesses, but it is important to understand its limitations. RAROC does not take into account all of the factors that can affect the profitability of an investment or business, such as changes in market conditions or the business's operating environment.

RAROC is also a subjective measure, and the results can vary depending on the assumptions that are used in the calculation. For example, the WACC is a subjective measure, and the choice of the discount rate can significantly affect the results of the RAROC calculation.

Despite its limitations, RAROC is a valuable tool for evaluating the profitability of investments and businesses. It is a more accurate measure of profitability than ROI, and it can be used to compare the profitability of different investments or businesses.