What is the most commonly used method for incorporating risk into the capital-budgeting decision? How is
this technique related to Principle 3: Risk Requires a Reward?
What will be an ideal response?
Under the risk adjusted discount rate approach in capital budgeting, if the risk associated with the investment is
greater than the risk involved in a typical endeavor, the discount rate is adjusted upward to compensate for this added
risk. Once the firm determines the appropriate required rate of return for a project with a given level of risk, the cash
flows are discounted back to the present at the risk-adjusted discount rate. Then the normal capital budgeting criteria
are applied, except in the case of the IRR. For the IRR, the hurdle rate with which the project's IRR is compared now
becomes the risk-adjusted discount rate. Expressed mathematically, the NPV using the risk-adjusted discount rate
becomes.
The use of risk-adjusted discount rates is based on the concept that investors demand higher returns for more risky
projects. This is the basic principle behind Principle 3: Risk Requires a Reward.
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