Question

An investment with a high risk margin has a high discount rate, which makes the net present value:

Select one:

a. higher.

b. unchanged, as the level of risk has no effect on the NPV.

c. zero.

d. lower.

Answer 1

The risk and uncertainty of the stock is directly related to the discount rate. When the risk increases, the discount rate also increases.

When the discount rate increases, the present value factor decreases.

For E.g.,

Discount factor of 1 year at 10% = 0.9091

Discount factor of 1 year at 8% = 0.9259

Discount factor of 1 year at 12% = 0.8929

If discount rate increases then the Present value factor decreases, this leads to low level of cash inflows when we discount them to present terms. Which inturn will lead to Low Net Present Value (NPV) (Discount cash inflow - Cash outflow).

So the answer is the Net present value will be lower