by The certainty equivalent is a guaranteed return that someone would accept now, rather than taking a chance on a higher, but uncertain, return in the future. Put another way, the certainty equivalent is the guaranteed amount of cash that a person would consider as having the same amount of desirability as a risky asset.
It is also another simplest method for calculating risk in capital budgeting info reduced expected cash inflows by certain amounts it can be employed by multiplying the expected cash inflows by certainly equivalent co-efficient in order the uncertain cash inflow to certain cash inflows.
Certainty Equivalent Cash Flow = Expected Cash Flow / (1 + Risk Premium)
Example
There are two projects A and B. Each involves an investment of Rs. 50,000. The expected cash inflows and the certainly co-efficient are as under:
| Project A | Project B | |||
| Yr | Cash inflows | Certainly co-efficient | Cash inflows | Certainly Co-efficient |
| 1 | 35,000 | 0.8 | 25,000 | 0.9 |
| 2 | 30,000 | 0.7 | 35,000 | 0.8 |
| 3 | 20,000 | 0.9 | 20,000 | 0.7 |
Risk-free cutoff rate is 10%. Suggest which of the two projects. Should be preferred.
Solution
Calculations of cash Inflows with certainly:
| Yr | Project A | Project B | ||||
| Cash Inflow | Certainly Co-efficient | Certain Cash Inflow | Cash Inflow | Certainly Co-efficient | Certain Cash Inflow | |
| 1 | 35,000 | .8 | 28,000 | 25,000 | .9 | 22,500 |
| 2 | 30,000 | .7 | 21,000 | 35,000 | .8 | 28,000 |
| 3 | 20,000 | .9 | 18,000 | 20,000 | .7 | 14,000 |
Calculation of present values of cash inflows:
| Year | Project A | Project B | |||
| Discount Factor @ 10% | Cash Inflows | Present Values | Cash Inflows | Present Value | |
| 1 | 0.909 | 28,000 | 25,452 | 22,500 | 20,453 |
| 2 | 0.826 | 21,000 | 17,346 | 28,000 | 23,128 |
| 3 | 0.751 | 18,000 | 13,518 | 14,000 | 10,514 |
| Total | 56,316 | 54,095 | |||
Project A = Net present value = Rs. 56,316 – 50,000 = Rs. 6,316
Project B = Net present value = 54,095 – 50,000 = Rs. 4,095
As the net present value of project, A in more than that of project B. Project A should be preferred.
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