ACCA Financial Management (F9) Certification Practice Exam

What does a higher discount rate typically indicate in investment analysis?

1. Lower risk associated with the investment

2. Higher potential returns over the project's duration

3. Greater uncertainty and higher risk in projected cash flows

4. Reduced overall investment expenditure

The correct answer is: Greater uncertainty and higher risk in projected cash flows

A higher discount rate in investment analysis typically indicates greater uncertainty and higher risk in the projected cash flows. When evaluating the present value of future cash flows, the discount rate reflects the opportunity cost of capital and the risk associated with those cash flows. If investors perceive higher risk in an investment, they demand a higher potential return as compensation for taking on that risk. Therefore, to account for the increased likelihood of variability in cash flows, a higher discount rate is applied. For example, investments in stable, low-risk environments (like government bonds) generally use lower discount rates because the projected cash flows are considered more certain. Conversely, a startup or a project in a volatile market might apply a higher discount rate due to the greater uncertainty and potential for fluctuations in revenue. This approach ensures that a higher risk factor is reflected in the investment’s valuation, guiding decisions on whether to proceed with the investment based on the anticipated returns in relation to the associated risks.