The risk-adjusted discount rate is based on the risk-free rate and a risk premium. The risk premium is derived from the perceived level of risk associated with a stream of cash flows for which the discount rate will be used to arrive at a net present value. The risk premium is adjusted upward if the level of investment risk is perceived to be high. When a high risk-adjusted discount rate is applied to a stream of cash flows, the net present value of those cash flows will be greatly reduced. Conversely, a low risk-adjusted discount rate will result in a higher net present value. A proposed investment with a higher net present value is more likely to be accepted. Thus, the discount rate is used to judge whether a proposed investment is acceptable. Other types of risks must also be considered, such as currency risk when a foreign investment is being evaluated.
Though the use of a risk-adjusted discount rate initially appears to be a highly regimented and quantitatively sound approach to evaluating risky investments, it is subject to one significant flaw, which is how the risk premium is derived. Managers could break the system by first calculating the maximum discount rate that will still result in their project being approved, and lobby in favor of the application of that discount rate - irrespective of the actual risk profile of the project.
The main advantages of the risk-adjusted discount rate are that the concept is easy to understand and it is a reasonable attempt to quantify risk. However, as just noted, it is difficult to arrive at an appropriate risk premium, which can render the results of the analysis invalid. This approach also assumes that investors are risk-averse, which is not always the case. Some investors will accept a high level of risk if they perceive a potentially large payoff from an investment in the future.