Which of the following describes the relationship between risk and the discount rate used in capital budgeting?

• A. Higher risk leads to a lower discount rate.
• B. Risk is ignored in discount rate decisions.
• C. Discount rate is determined independently of risk.
• D. Higher risk leads to a higher discount rate, reducing the net present value.

Answer: (D)

Risk affects the discount rate used in capital budgeting because investors demand a return that compensates for the uncertainty of a project’s cash flows. The discount rate represents the cost of capital or the required rate of return. When risk increases, the required return goes up, so the discount rate rises. A higher discount rate lowers the present value of all future cash flows, which in turn lowers the net present value. So, higher risk leads to a higher discount rate, reducing the NPV. This reflects why risk isn’t ignored and why the rate isn’t determined independently of risk—the two are linked through the investor’s required compensation for risk.