What discount rate was used for risky investments in the example?

What discount rate was used for risky investments in the example?

• A. 12%
• B. 20%
• C. 8%
• D. 15%

Answer: (B)

The main concept here is that the discount rate for any investment should reflect the risk of the cash flows. When a project is riskier, you raise the rate to compensate investors for that uncertainty; this higher rate lowers the present value of expected future cash inflows, making the hurdle for acceptance more stringent. In the example, the investment was treated as risky, so a twenty percent discount rate was used to capture the extra return investors would demand for taking on that risk. This higher rate ensures the evaluation accounts for variability and potential shortfalls in cash flows, not just the expected amount. Lower rates would imply less risk and could make a risky project look more attractive than it truly is, because they don’t adequately penalize the uncertainty. A rate like twenty percent is appropriate when the risk premium is substantial, aligning the decision with the level of risk described in the scenario.

The main concept here is that the discount rate for any investment should reflect the risk of the cash flows. When a project is riskier, you raise the rate to compensate investors for that uncertainty; this higher rate lowers the present value of expected future cash inflows, making the hurdle for acceptance more stringent.

In the example, the investment was treated as risky, so a twenty percent discount rate was used to capture the extra return investors would demand for taking on that risk. This higher rate ensures the evaluation accounts for variability and potential shortfalls in cash flows, not just the expected amount.

Lower rates would imply less risk and could make a risky project look more attractive than it truly is, because they don’t adequately penalize the uncertainty. A rate like twenty percent is appropriate when the risk premium is substantial, aligning the decision with the level of risk described in the scenario.