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CMA Final · Strategic Financial Management · Evaluation of Risky Proposals for Investment Decisions

Under the risk-adjusted discount rate (RADR) approach, which statement is correct for a project with higher risk than the firm's existing projects?

Under the risk-adjusted discount rate approach, a riskier project is discounted at a rate above the firm's normal rate, by adding a risk premium. Because the higher rate compounds over time, distant cash flows are reduced more heavily than near ones.

  1. AA lower rate than the risk-free rate is applied
  2. BThe risk-free rate is applied to the cash flows
  3. CA rate above the firm's normal rate is applied, penalising distant cash flows more heavilyCorrect
  4. DCash flows are multiplied by a coefficient and discounted at the risk-free rate

Explanation

RADR adds a risk premium to the discount rate, so riskier projects are discounted at a higher rate. Because compounding applies, later cash flows are penalised more. The option about coefficients describes the certainty equivalent method.

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