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2 the npv decision rule of accepting only those

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Unformatted text preview: opular riskadjustment technique that employs the net present value (NPV) decision method.2 The NPV decision rule of accepting only those projects with NPVs $0 will continue to hold. Close examination of the basic equation for NPV, Equation 9.1, should make it clear that because the initial investment (CF0) is known with certainty, a project’s risk is embodied in the present value of its cash inflows: n t CFt k)t 1 (1 Two opportunities to adjust the present value of cash inflows for risk exist: (1) The cash inflows (CFt) can be adjusted, or (2) the discount rate (k) can be adjusted. Adjusting the cash inflows is highly subjective, so here we describe the more popular process of adjusting the discount rate. In addition, we consider the portfolio effects of project analysis as well as the practical aspects of the riskadjusted discount rate. Determining Risk-Adjusted Discount Rates (RADRs) A popular approach for risk adjustment involves the use of risk-adjusted discount rates (RADRs). This approach uses Equation 9.1 but employs a risk-adjusted discount rate, as noted in the following expression:3 n NPV t1 (1 CFt RADR)t CF0 (10.2) 2. The IRR could just as well have been used, but because NPV is theoretically preferable, it is used instead. 3. The risk-adjusted discount rate approach can be applied in using the internal rate of return as well as the net present value. When the IRR is used, the risk-adjusted discount rate becomes the cutoff rate that must be exceeded by the IRR for the project to be accepted. When NPV is used, the projected cash inflows are merely discounted at the riskadjusted discount rate. 434 PART 3 Long-Term Investment Decisions risk-adjusted discount rate (RADR) The rate of return that must be earned on a given project to compensate the firm’s owners adequately—that is, to maintain or improve the firm’s share price. The risk-adjusted discount rate (RADR) is the rate of return that must be earned on a given project to compensate the firm’s owners adequately—that is, to maintain or improve the firm’s share price. The higher the risk of a project, the hi...
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