The certainty equivalent approach is a risk evaluation technique. Which of the f

Question

The certainty equivalent approach is a risk evaluation technique. Which of the following statements is/are correct?
I. Certainty equivalents adjust the cash flows in the numerator of the NPV equation.
II. Using the Certainty Equivalent Approach would mean using the risk-free rate and not the cost of capital as the disount rate in the denominator of the NPV equation.

Project C has an outlay of $1,000 dollars. If the project is expected to pay $120 in cash flow per year from t=1 to t=20, what would be the project's NPV? Assume that the cost of capital is 10%. The company uses the risk-adjusted discount rate approach and this project is classified as a normal risk project. For normal risk projects, the company uses the cost of capital as the discount rate (10%). For projects that are of higher risk, they use 15% and use 5% for projects with subnormal risk.

If I had a net investment of $40,000 with cash inflows amounting to $20,000 per year for three years (years 1-3) what would be the discounted payback on the project if the cost of capital is 10%? If I had a cutoff of two years in discounted payback, would I accept this project?

Explanation / Answer

1. Both of them are correct.

2. Present value of all cash flows = PVIFA (20years, 10%) * 120 - 1000

= 8.51*120 - 1000 = 1021.63 - 1000

NPV = 21.63

3.

For 2 years cutoff, we should not accept the project.

Y1 20000        0.91 18,181.82 18,181.82 Y2 20000        0.83 16,528.93 34,710.74 Y3 20000        0.75 15,026.30 49,737.04 Discounted Payback        2.65 years

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