Q. Define Risk-adjusted discount rates?
One technique in this heading is the assignment of investment projects to one of a set of risk classes all of which has a different discount rate. The assessment of threat depends here on the classification of the project for instance asset replacements projects are considered to be low risk while new product launches may be placed in a high risk category. The discount rate applied after that increases with the risk class to which a project is assigned. One difficulty with this technique is that there may be no academic justification for the discount rate assigned to each risk class consequently that there is no explicit link between risk and required rate of return.
An alternative approach is to raise the discount rate by an amount that reflects the perceived risk of an investment project that is to add a risk premium reflecting project risk. While this is able to be done on a rule of thumb basis so that a different discount rate is used for each project it would be preferable to use a technique that assesses project risk and derives a required rate of return based on that assessment.