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5. Risk-adjusted discount rate approach Aa Aa The risk-adjusted discount rate (RADR) approach recognizes that different investment projects exhibit different risk profiles. Moreover, based on the risk profile of an individual project, the rate of return used to discount the project's expected cash flows can be adjusted to accommodate the specific riskiness of that specific project. This generally involves adding a project-specific risk premium to the market's risk-free rate to adjust the discount rate used to discount the proposed project's expected future cash flows and determine the project's expected net present value. In your role as a financial analyst, you've been tasked with evaluating your company's investment projects. If you believe that a specific investment project exhibits a level of riskiness that is commensurate with the company's other projects then you would want to use a discount rate that is equal to: O the firm's average cost of capital O the market's risk-free rate Consider the case of Fantasy Aeronautics Fantasy Aeronautics is owned 100% by private shareholders and carries no debt on its books. The company's beta is estimated to be 1.0. The company uses a risk-free rate of 8%, and the market expects a return of 12% The graph below plots the security market line (SML). Based on your understanding of the capital asset pricing model and the risk-adjusted discount rate approach toward project risk, plot the following points on the graph Use point A (orange square) to show the rate of return the company should require on a project with average risk. Use point B (green triangle) to show the rate of return the company should require on a project with a beta of 1.30 Tool tip: Mouse over the points on the graph to see their coordinates