4.2.1 Risk and the discount rate
Remember that in Section 3, you saw that the reasoning behind the discount rate is that it represents the return that would be demanded by investors in order to invest in a project. The higher the risk of a project, the higher the return that would be demanded to invest in that project. A higher rate compensates an investor for the possibility that the future cash flows are not actually received. A higher risk means that future cash flows are less certain, so where the risk of a project is higher, a higher discount rate should be used.
So, the most basic way to adjust the discount rate for increased risk is to discount future cash flows by an appropriate amount. Throughout most of this course, the discount rate has been supplied to you as the cost of capital or the required return. Using the cost of capital is acceptable if a project has the same risk as the on-going operations in an organisation. However, if the project has a risk different from the normal operations in an organisation, a different discount rate should be used to reflect this. Section 3 discussed how the CAPM can be used to estimate the risk of a project by using the beta of companies which undertake similar projects or operate in the same industry as a comparison.