12.4 Risk-Adjusted Discount Rates

  1. LG4

The approaches for dealing with risk that have been presented so far enable the financial manager to get a “feel” for project risk. Unfortunately, they do not explicitly recognize project risk. We will now illustrate the most popular risk-adjustment technique that uses the net present value (NPV) decision method. The NPV decision rule of accepting only those projects with NPVs > $0 will continue to hold. Close examination of the basic equation for NPV, Equation 10.1, should make it clear that because the initial investment (CF0) is known with certainty, a project’s risk is embodied in the present value of its cash inflows:

NPV=t=1nCFt(1+r)tCF0

Two opportunities to adjust the present value of cash inflows ...

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