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As a business owner you have two business opportunities that are presented to you. Both options...

As a business owner you have two business opportunities that are presented to you. Both options will present future cash flows over a three year period. To determine what option you are going to select a net present value analysis will be performed. One of the options is rather risky and the future cash flows are not certain. The other option is not that risky and future cash flows are known and consistent. Explain the relationship between the risk of the two options with the future cash flows (does risk increase or decrease NPV?) and the discount rate used to calculate NPV.

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Answer #1

NPV = Present Value of Cash Inflows - Present Value of Cash Outflows

To calculate the Present Value, Future Cash Flows are discounted at a suitable to arrive at their Present Value.

That rate is majorly represents the minimum expected return from the project.

Higher the rish with Cash Fkows not certain, higher will be the expectations and higher will be the Discounting Factor.

Therefore, the risky option has to be discounted using a higher rate than the rate used to discount the one with the consistent and known Cash Flows.

Higher DIscounting Factor will lead to a decrease in NPV.

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