Corporate Finance - Assessment Tests - Risk and Refinements

Risk-adjusted discount rates (RADRs) are the risk-adjustment factors that represent the percent of estimated cash inflows that investors would be satisfied to receive for certain rather than the cash inflows that are possible for each year.

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The risk-adjusted net present value is the rate of return that a project must earn to maintain or improve the firm's share price.

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The risk-adjusted discount rate can be computed as the risk free rate plus the product of a project's beta and the market return.

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In applying risk-adjusted discount rates to project selection, projects falling above the SML would have a negative NPV and those falling below the SML would have a positive NPV.

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Even though a business firms can be viewed as a portfolio of assets, firms are not rewarded for selecting a diversified portfolio of assets because investors can more efficiently diversify away unsystematic risk on their own.

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In the real world, different projects have different levels of risk. As a result, the acceptance of a particular project usually has an enormous impact on the firm's overall risk.

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The theoretical basis from which the concept of risk-adjusted discount rates is derived is

• the Gordon model

• the Capital Asset Pricing Model

• the Simulation theory

• the Basic Cost of Money

In a capital budgeting context, risk is generally thought of as the chance that NPV and IRR will provide conflicting recommendations to management.

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The risk-adjusted discount rate approach to evaluating projects with unequal lives converts the net present value of unequal-lived, mutually exclusive projects into an equivalent annual amount.

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When unequal-lived projects are independent, the length of the projects' lives is not critical.

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