Question

the higher the risk of a project, the higher its risk-adjusted discount rate and thus the lower the net present value for a given stream of cash inflows.

Answer 1

The expected rate of return projects the average investment earnings, while risk evaluates uncertainty in those returns, affecting the actual rate of return. High-risk investments lead to higher discount rates and lower net present values for the same inflows. Changes in risk and return influence the flow of financial capital between investments.

Step-by-step explanation:

The relationship between risk, expected rate of return, and actual rate of return is central to financial decision-making and investment analysis. The expected rate of return is an average estimate of the earnings an investment might generate, factoring in both potential interest payments and capital gains. Risk refers to the likelihood that the actual returns deviate from the expected rate, and it can include factors such as default risk (the chance a borrower won’t repay a loan or bond) and interest rate risk (the risk that interest rates will change unfavorably after a fixed-income investment is made).

Investments that are perceived as high-risk demand higher risk-adjusted discount rates when analyzing their value through net present value (NPV) calculations. This reflects investors' need for higher potential returns to offset the increased uncertainty.

Consequently, a high-risk project will typically have a lower NPV for a given stream of cash inflows, because future cash flows are discounted at a higher rate to account for the risk. Simultaneously, if risks increase or returns decrease for an investment, financial capital may move away, shifting supply curves in markets as investors seek better opportunities.

Answer 2

The statement addresses the inverse relationship between a project's risk and its net present value, explaining that a higher risk-adjusted discount rate, due to increased risk, will result in a lower net present value for the same expected cash inflows.

Step-by-step explanation:

The statement that "the higher the risk of a project, the higher its risk-adjusted discount rate and thus the lower the net present value for a given stream of cash inflows" encapsulates the relationship between risk and valuation in financial investments. The expected rate of return is what an investor anticipates earning from an investment, which is expressed as a percentage and is averaged over a certain time frame. However, risk involves the uncertainty around that expected return and varies based on factors like default risk and interest rate risk.

When evaluating a project or investment, a higher risk leads to a higher risk-adjusted discount rate because investors demand a greater return for taking on additional uncertainty. Consequently, applying a higher discount rate reduces the present value of future cash flows. Therefore, high-risk projects typically have lower net present values compared to lower-risk projects with the same expected future cash inflows.