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Certainty Equivalent Factor

The document discusses the certainty equivalent factor approach to capital budgeting. It defines the certainty equivalent factor as the ratio of assured cash flows to uncertain cash flows. It converts uncertain cash flows into certain cash flows by multiplying them by the CEF. It then discounts the certain cash flows at the risk-free rate to calculate the NPV. If the NPV is positive, the project can be accepted. An example is provided to illustrate computing certain cash flows, applying discount rates, and determining that a project should be rejected if it has a negative NPV.

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447 views2 pages

Certainty Equivalent Factor

The document discusses the certainty equivalent factor approach to capital budgeting. It defines the certainty equivalent factor as the ratio of assured cash flows to uncertain cash flows. It converts uncertain cash flows into certain cash flows by multiplying them by the CEF. It then discounts the certain cash flows at the risk-free rate to calculate the NPV. If the NPV is positive, the project can be accepted. An example is provided to illustrate computing certain cash flows, applying discount rates, and determining that a project should be rejected if it has a negative NPV.

Uploaded by

Parth Sahni
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CAPITAL BUDGETING – Certainty Equivalent Factor

Meaning

Certainty Equivalent factor (CEF) is the ratio of assured cash flows to uncertain cash flows. Under this
approach, the cash flows expected in a project are converted into risk-less equivalent amount. The
adjustment factor used is called CEF. This varies between 0 and 1. A co-efficient of 1 indicates that cash
flows are certain. The greater the risk in cash flow, the smaller will be CEF ‘for receipts’, and larger will
be the CEF ‘for payments’. While employing this method, the decision maker estimates the sum she
must be assured of receiving, in order that she is indifferent between an assured sum and expected
value of a risky sum.

Formula:

CCF
CEF 
UCF

CEF = CCF/UCF

In this equation, the term CCF refers to the amount, which decision-maker is willing to receive as an
assured sum in lieu of an unassured sum. The term UCF means uncertain cash flows.

Method of Computation under CE approach:

Step 1: Convert uncertain cash flows to certain cash flows by multiplying it with the CEF.

Step 2: Discount the certain cash flows at the risk free rate to arrive at NPV.

Decision rule: If the resultant NPV is positive project can be accepted.


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Example:

Blue Prints Ltd., having 10% cost of capital is considering a project with the following expected cash
flows. The risk free rate is 8%. The NPV at 10% is found to be positive.

Year Cash Flows ($)


0 -22500
1 17500
2 12500
3 12500

Due to uncertainties about the future cash receipts, the management decides to adjust these cash flows
to certainty equivalent, by taking only 60%, 55% and 50% 0f cash flows for years 1 to 3 respectively.
Assess the validity of project

Solution:

We compute the certain cash flows and NPV at 8%

Year Cash Flow CF CCCF Present Value PV


factor @ 8%
0 -22500 1 -22500 1 -22500
1 17500 .6 10500 .926 9723
2 12500 .55 6875 .857 5892
3 12500 .5 6250 .794 4963
NPV -1922

Since NPV is negative project should be rejected.

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