One of the basic financial principles is that the value of any asset (whether it

Question

One of the basic financial principles is that the value of any asset (whether it be a stock, a bond, or a firm as a whole) is the present value of that asset’s future cash flows. As you learned in this chapter, finding present values requires determining a discount rate. Assume you want to buy a business, and you want to find the present value of its future cash flows. Name at least one variable you should consider in determining the correct discount rate to use and explain its role in discount rate determination. If possible, try to identify a variable that has not yet been mentioned by your classmates.

Explanation / Answer

Risk of project

Different discount rates should be used while evaluating projects using NPV (Net Present Value) method, but the discount rate should be more than the WACC (Weighted Average Cost of Capital), thus, the firm will be able to meet the expectation of shareholders. Projects risk profile differ significantly, thus, the rate used for discounting while using NPV method should be adjusted with risk of respective project. Thus, the risk adjusted discount rate should be used to evaluate projects.

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