Risk-adjusted return on capital, also know as RAROC, is a common way to calculate the return capital employed in a business. Finance theory states that higher-risk projects have the potential to provide higher returns while lower-risk projects typically provide lower investment returns. Business owners, investors, and accountants can use RAROC to compare or help value two very different projects or businesses in a meaningful apples-to-apples way.
The formula for RAROC is: RAROC = (Revenue – Expenses – Expected Loss + Income from Capital) / Capital
In this formula, expected loss equals the average loss expected over a period of time.
As an example, assume Project A needs $500,000 in capital. Revenue from the project is expected to be $125,000 and expenses total $40,000. The industry average expected loss on a project of this type is $25,000, and the income from the capital in the project equals $10,000. Project B is a very different type of project. It has capital requirements of $100,000; revenue and expenses are expected to be $15,000 and $5,000 respectively. The expected loss is $2,000, and the income from the capital is $0. Based on these numbers, the RAROCs are:
Project A: ($125,000 – $40,000 – $25,000 + $10,000) / $500,000 = $70,000 / $500,000 = 14%
Project B: ($15,000 – $5,000 – $2,000 + $0) / $100,000 = $8,000 / $100,000 = 8%
The RAROC calculations show that Project A is the better investment. RAROC is an easy formula that can help any business owner, analyst, or accountant quickly gain insights into how different types of projects perform after adjusting for the projects’ inherent risks.