The Risk-adjusted Discount Rate Approach to incorporate risk in the capital budgeting analysis has certain virtues. First, it is simple to calculate and easy to understand. Moreover companies in actual practice apply different standards of cost of capital for different projects. It has, therefore, the merit of operational feasibility.
However, it is beset with certain operational and conceptual difficulties. The principal operational difficulty of this approach to the incorporation of risk relates to the determination of the adjusted discount rate. While it is logical to assume that projects which involve more risk should be discounted at a higher rate and vice-versa, the difficulty encountered is how to precisely press a higher risk in terms of a higher discount rate. In other words, determining an appropriate discount rate in consonance with differing degrees of risks of various projects or, over the years the same project, is bound to be arbitrary and, therefore, inconsistent in application. It is doubtful if the exercise would give objective results.
The second criticism of this approach is that it does not make direct use of the information available from the probability distribution of expected future cash. Moreover, conceptually, approach adjusts the wrong element. It is the future cash flow of a project which is subject to risk. What is needed is that the cash flow should be adjusted and not the required rate of return.
Finally, the process of adding the risk premium to the discount rate leads to a compounding risk-over time. This is not a theoretically desirable practice. It is because the discounting process should only take into account time value considerations and not risk considerations. In words, this method implies that risk necessarily increases with time and, therefore, pro which risk does not necessarily increase with time may not be properly evaluated by this method.
In brief, this approach can at best be described as a crude method of incorporating risk into capital budgeting analysis.