How does risk affect the discount rate used in capital budgeting?

How does risk affect the discount rate used in capital budgeting?

• A. Higher risk leads to a lower discount rate.
• B. Risk has no effect on the discount rate.
• C. Higher risk leads to a higher discount rate, increasing the net present value.
• D. Higher risk leads to a higher discount rate, reducing the net present value.

Answer: (D)

Risk drives the required return used in project appraisal. When a project is riskier, investors demand a higher return, so the discount rate rises. Since NPV is the sum of expected cash flows discounted by (1 + discount rate)^t, a higher discount rate makes future cash flows worth less today, reducing the NPV. So, higher risk leads to a higher discount rate, which lowers the net present value. The other options conflict with how risk affects the hurdle rate or with the directional effect of a higher discount rate on NPV.

Risk drives the required return used in project appraisal. When a project is riskier, investors demand a higher return, so the discount rate rises. Since NPV is the sum of expected cash flows discounted by (1 + discount rate)^t, a higher discount rate makes future cash flows worth less today, reducing the NPV. So, higher risk leads to a higher discount rate, which lowers the net present value. The other options conflict with how risk affects the hurdle rate or with the directional effect of a higher discount rate on NPV.