Certainty Equivalent Method

13th October 2021 0 By indiafreenotes

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.