Introduction to Finance

risk-adjusted discount rate (RADR)
approach does this, adjusting the required rate 
of return at which the analyst discounts a project’s cash fl ows. Projects with higher (or lower) 
risk levels demand higher (or lower) discount rates. A project is expected to enhance share-
holder wealth only if its NPV based on a risk-adjusted discount rate is positive.
One way to determine project RADRs is for the fi rm’s managers to use past experience 
to create risk classes, or categories, for diff erent types of capital budgeting projects. Each risk 
category can be given a generic description to indicate the project types it should include, and 
a required rate of return or “hurdle rate” to assign those projects.
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An example is shown in 
Table 17.8
, which assigns projects of average risk (or those 
whose risk is about the same as the fi rm’s overall risk) a discount rate equal to the fi rm’s 
cost of capital. That is, projects of average risk must earn an average return, as defi ned by 
the fi rm’s cost of fi nancing. Projects with below-average risk levels are discounted at a rate 
below the cost of capital. Projects of above-average risk must earn premiums over the fi rm’s 
cost of capital to be acceptable. Subjectivity enters this process as management must decide 
the number of categories, the description of each risk category, and the required rate of 
return to assign to each category. Diff erences of opinion or internal fi rm politics may lead 
to controversy in classifying a project. Clearly defi ned category descriptions can minimize 
such problems.
For example, let’s use the previously presented data for projects A and B to illustrate 
the use of risk-adjusted discount rates. Let’s assume that project A and B are independent 
projects. Project A involves expansion in an existing product line, whereas project B is for a 
new product. The fi rm’s cost of capital, 10 percent, would be the appropriate discount rate for 
project A. Recall that this would result in a net present value of $1,982.
In contrast, a higher discount rate, say 12 percent, for project B (that is, is the 10 percent 
cost of capital plus a 2 percentage point risk premium), might be judged appropriate by the