What is 'Return On Risk-Adjusted Capital - RORAC'
The return on risk-adjusted capital (RORAC) is a rate of return statistic commonly used in financial analysis, where varying projects, endeavors and investments are evaluated based on capital at risk. Projects with different risk profiles are easier to compare to each other once their individual RORAC values have been calculated.
BREAKING DOWN 'Return On Risk-Adjusted Capital - RORAC'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 to quantify and maintain acceptable risk-exposure levels. This calculation is similar to 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 asset being analyzed.
The RORAC formula is straightforward. To calculate RORAC, take the net income of the project or firm and divide it by risk-weighted assets. For example, 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 total revenues of $100,000 and total expenses of $50,000. The total risk-weighted assets involved in the project is $400,000. Project 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 RORACs are calculated as:
Project A RORAC = ($100,000 - $50,000) / $200,000 = 12.5%
Project B RORAC = ($200,000 - $100,000) / $900,000 = 11.1%
Even though Project B had twice as much revenue as Project A, once the risk-weighted capital of the projects are taken into account, it is clear that Project A has a better RORAC.
RORAC is similar to, and easily confused with, two other statistics. Risk-adjusted return on capital (RAROC) is usually defined as the ratio of risk-adjusted return to 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 value at risk to arrive at RAROC. Another statistics similar to RORAC is the risk-adjusted return on risk-adjusted capital (RARORAC). This statistic is calculated by taking the risk-adjusted return and dividing it by economic capital, adjusting for diversification benefits. It uses guidelines defined by the international risk standards covered in Basel II.