Risk Adjusted Discount Rates

Another way to incorporate risk in managerial decision making is to adjust the discount rate or denominator of the basic valuation model (Equation 14.7). Like certainty equivalent factors, risk-adjusted discount rates are based on the trade-off between risk and return for individual investors. Suppose an investor is indifferent to a riskless asset with a sure 5 percent rate of return, a moderately risky asset with a 10 percent expected return, and a very risky asset with a 15 percent expected return. As risk increases, higher expected returns on investment are required to compensate for additional risk. Observe also that the required risk premium is directly related to the level of risk associated with a particular investment. This is a common situation.

The basic valuation model shown in Equation 14.7 can be adapted to account for risk through adjustment of the discount rate, i, where

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