Principles of Managerial Finance, 15th Edition

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:

$$\text{NPV}={\displaystyle \sum _{t=1}^n}{\displaystyle \frac{C{F}_t}{{\left(1+r\right)}^t}}-C{F}_0$$

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