The certainty equivalent approach is a risk evaluation technique. Which of the f
ID: 2700738 • Letter: T
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.