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ACCA Applied Skills · Financial Management · Adjusting for risk and uncertainty in investment appraisal

Which statement about adjusting the discount rate for project risk is correct?

A higher discount rate is applied to riskier projects, which reduces their NPV. The risk premium is added to the cost of capital so that future cash flows are discounted more heavily, making risky projects harder to accept.

  1. AA higher discount rate is applied to riskier projects, which reduces their NPVCorrect
  2. BA lower discount rate is applied to riskier projects, which increases their NPV
  3. CThe cash flows are multiplied by probabilities and the rate is left unchanged
  4. DThe discount rate is reduced for later years to reflect falling risk

Explanation

The risk-adjusted discount rate method adds a premium to the cost of capital for riskier projects. A higher rate lowers present values and so the NPV. It treats risk as increasing over time, not falling.

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