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IAI Actuarial Core Principles · Business Finance · Cost of capital and evaluating investment projects

A company is appraising a new plant. Management decides to add a 3 percentage point risk premium to the usual discount rate because the project is more uncertain than the firm's existing business. Which statement best describes the effect and limitation of this risk-adjusted discount rate approach?

The risk-adjusted discount rate reduces distant cash flows more heavily because the higher rate compounds over time, but the premium added is subjective and not objectively tied to the project's actual risk. It still requires cash flow forecasts and gives no distribution of outcomes.

  1. AIt lowers the NPV of all projects equally, regardless of when cash flows occur
  2. BIt penalises distant cash flows more heavily, but the premium chosen is subjective and lacks a precise link to the project's riskCorrect
  3. CIt produces a probability distribution of possible NPVs for the project
  4. DIt removes the need to estimate future cash flows
  5. It guarantees that the project with the highest IRR is accepted

Explanation

A higher discount rate compounds over time, so later cash flows are reduced proportionally more than earlier ones. The weakness is that the size of the premium is a judgement and is not derived objectively from the project's risk. It does not give a distribution of NPVs (that needs simulation) and still needs cash flow estimates.

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