1. Neustal, Inc. has decided to use the certainty equivalent method in determini

Question

1.              Neustal, Inc. has decided to use the certainty equivalent method in determining whether a new investment should be made. The expected cash flows associated with this investment and the estimated certainty equivalents are as follows:

Year                Cash Flows                 CE coefficients

0                    -$90,000                            1.00

1                        25,000                            0.95

2                        30,000                            0.90

3                        30,000                            0.83

4                        25,000                            0.75

5                        20,000                            0.65

Given that Neustal’s normal required rate of return is 18% and that the after-tax risk-free rate is 7%, should this project be accepted?

Explanation / Answer

Calculation of NPV of the project using certainty equivalent method Year Cash flow CE coefficients Adjusted cash flow PV factor at 7% Present Values 0 -90000 1 -90000 1                  -90,000.00 1 25000 0.95 23750 0.934579439                    22,196.26 2 30000 0.9 27000 0.873438728                    23,582.85 3 30000 0.83 24900 0.816297877                    20,325.82 4 25000 0.75 18750 0.762895212                    14,304.29 5 20000 0.65 13000 0.712986179                      9,268.82 NPV                        -321.97 At risk free rate of 7% , the project has a negative NPV as -$321.97 , hence project should not be accepted.

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