When an investment is considered risky ______.

When an investment is considered risky ______.

• A. adjust none of the inputs
• B. adjust only cash flows
• C. adjust only the discount rate
• D. adjust both cash flows and the discount rate

Answer: (D)

Risk affects both what you expect to receive from an investment and the return you demand for taking that risk. When an investment is risky, it’s appropriate to adjust the forecasted cash flows to reflect uncertainty—for example, using probability-weighted outcomes or scenario analysis to show possible upsides and downsides. At the same time, you should raise the discount rate to incorporate the higher required return for bearing risk, which lowers the present value of those cash flows. Doing both gives a more accurate, conservative assessment than adjusting only one side. If you adjust only cash flows, you might still understate the cost of risk; if you adjust only the discount rate, you might misstate the likelihood of those cash flows materializing. Adjusting both components aligns the valuation with the investment’s risk level.

Risk affects both what you expect to receive from an investment and the return you demand for taking that risk. When an investment is risky, it’s appropriate to adjust the forecasted cash flows to reflect uncertainty—for example, using probability-weighted outcomes or scenario analysis to show possible upsides and downsides. At the same time, you should raise the discount rate to incorporate the higher required return for bearing risk, which lowers the present value of those cash flows. Doing both gives a more accurate, conservative assessment than adjusting only one side. If you adjust only cash flows, you might still understate the cost of risk; if you adjust only the discount rate, you might misstate the likelihood of those cash flows materializing. Adjusting both components aligns the valuation with the investment’s risk level.