ADJUSTMENT OF RISK AND UNCERTAINTY IN CAPITAL BUDGETING DECISION Numerical
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What is the certainty equivalent (CE) coefficient used for in capital budgeting?
The certainty equivalent coefficient (α) converts uncertain cash flows into certain equivalents by multiplying expected cash flows by a risk-adjustment factor between 0 and 1, where a lower α reflects higher risk.
What is the certainty equivalent cash flow when α = 0.8 and expected cash flow is ₹50,000?
Certainty equivalent cash flow is ₹40,000.
How is the certainty equivalent coefficient (α) mathematically defined?
α = Certain cash flow / Risky (expected) cash flow; a value closer to 1 indicates low risk while a value closer to 0 indicates high risk.
If a project has a risky cash flow of ₹1,00,000 and CE coefficient of 0.9, what is the risk-adjusted cash flow?
Risk-adjusted cash flow is ₹90,000.
What is the formula for NPV using the certainty equivalent approach?
NPV = Σ [αt × CFt / (1 + Rf)^t] – Initial Investment, where αt is the CE coefficient for year t, CFt is the expected cash flow, and Rf is the risk-free rate.
How is the NPV calculated under the certainty equivalent method with risk-free rate of 6% and CE cash flows?
NPV = sum of CE cash flows discounted at 6% minus initial investment.
Why is the risk-free rate used as the discount rate in the certainty equivalent method?
Because the cash flows have already been adjusted for risk through the certainty equivalent coefficient, discounting at the risk-free rate avoids double-counting of risk.
What RADR should be applied if risk-free rate is 8% and risk premium for a high-risk project is 5%?
RADR = 13% (8% + 5%).
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