ACCA Financial Management (F9) Certification Practice Exam

In risk adjusted discounting, what happens when the risk level is high?

1. Lower cost of capital is applied

2. A constant rate is applied

3. A higher cost of capital is used

4. No adjustments are made

The correct answer is: A higher cost of capital is used

In risk-adjusted discounting, a higher cost of capital is employed to reflect the increased risk associated with the investment or project. When the risk level is high, investors and analysts understand that there is a greater chance of realizing lower than expected returns or even losses. To compensate for this elevated risk, the required return, represented as the cost of capital, is increased. This approach ensures that the risk involved in the investment is adequately factored into the valuation. By using a higher discount rate, future cash flows are discounted more heavily, effectively lowering their present value and making it clear that the investment's risk has a significant impact on its attractiveness. In contrast, applying a lower cost of capital, using a constant rate, or making no adjustments would not appropriately address the heightened uncertainty associated with high-risk scenarios, thus failing to provide an accurate valuation of the investment's potential outcomes.