Explain the Certainty Equivalent Approach

Question

Examlex · Accepted Answer

The Answer is The certainty equivalent approach makes risky projects less acceptable by lowering the cash flow estimates. This method asks the decision makers to consider each forecast cash flow individually and come up with a lower, risk free cash flow that they would consider equally as attractive as the risky cash flow that's been forecast.
The certainty equivalent technique involves having decision makers select a certainty equivalent for every cash flow in the project. That's usually done by picking a certainty equivalent factor between zero and 1.0 for each cash flow and multiplying the cash flow by the factor to arrive at the certainty equivalent figure. It allows the decision maker to recognize particularly risky years and put in lower factors for those years. Once the stream of certainty equivalent cash flows is developed, the risk adjusted NPV is calculated by discounting the stream back to the present. The risk-free rate is used as the discounting rate in the NPV calculation.

Explain the Certainty Equivalent Approach

Definitions: