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464 Corporate Finance BRILLIANT’S

coefficient. If the risk associated with the âbmo go Ow‹S>r hþB© [añH$ A{YH$ h¡ Vmo H$moB{\${eEÝQ> H$_
projected cash flow is higher, the coefficient will hmoJm Am¡a BgHo$ {dnarV [añH$ H$_ hmoZo na H$moB{\${eEÝQ>
be lower and vice-versa. A{YH$ hmoJmŸ&
(ii) Calculation of Present Value: After (ii) àoOoÝQ> d¡ë`y H$s JUZm… Ano{jV H¡$e âbmo H$mo
converting expected cash flow into certainty gQ>}ZQ>r BpŠdd¡boÝQ²>g _| n[ad{V©V H$aZo Ho$ ~mX Bg
equivalents, the second step under this EàmoM H$m Xygam ñQ>on àoOoÝQ> d¡ë`y H¡$bŠ`wboQ> H$aZm h¡Ÿ&
approach is to calculate their present values. BgHo$ {bE {Og {S>ñH$mCpÝQ>¨J aoQ> H$m Cn`moJ {H$`m
For this purpose, the rate of discounting used OmVm h¡ dh `m Vmo [añH$ \«$s aoQ> hmoVm h¡ AWdm Eogm aoQ>
is either the risk free rate or the rate which is Omo Q>mB_ d¡ë`y Am°\$ _Zr H$mo R>rH$ T>§J go àH$Q> H$aVm
appropriate to reflect the time value of money.
It is the same discount rate which is used for h¡Ÿ& `h dhr {S>ñH$mCÝQ> aoQ> h¡ Omo gm_mÝ`V… H¡${nQ>b
calculating the present value in the normal EŠgnopÝS>Ma Ho$ _yë`m§H$Z hoVw àoOoÝQ> d¡ë`y H$s JUZm _|
course of evaluating capital expenditure. à`wº$ hmoVm h¡Ÿ&
Accept-Reject Rule ñdrH¥${V Ed§ AñdrH¥${V gå~ÝYr {Z`_
The decision criteria may be either the NPV {ZU©` H$m AmYma `m Vmo NPV _oWS> AWdm IRR
method or the IRR method. If the NPV method is _oWS> hmo gH$Vr h¡Ÿ& `{X NPV _oWS> AnZm`r OmVr h¡ Vmo
used, the proposal would be accepted if the NPV ànmoOb V~ ñdrH¥${V `mo½` hmoJm O~{H$ gQ>}ZQ>r BpŠdd¡boÝQ>
of the certainty equivalent cash flow is positive, H¡$e âbmoO H$s NPV nm°{O{Q>d h¡ AÝ`Wm Bgo [aOoŠQ> H$a
otherwise it would be rejected. If the IRR method {X`m OmEJmŸ& `{X IRR _oWS> H$mo AnZm`m OmVm h¡ Vmo
is used, the IRR calculated on the basis of cer- gQ>}ZQ>r BpŠdd¡boÝQ> H¡$e âbmo Ho$ AmYma na IRR H$s
tainty equivalent cash flows would be compared JUZm H$s OmEJr AWdm BgH$r VwbZm [añH$ \«$s {S>ñH$mCÝQ>
with the risk free discount rate. If the IRR is higher aoQ> go H$s OmEJrŸ& `{X IRR [añH$ \«$s aoQ> H$s VwbZm _|
than risk free rate, the investment project would A{YH$ h¡ Vmo BÝdoñQ>_oÝQ> àmoOoŠQ> ñdrH¥$V {H$`m OmEJm
be accepted, otherwise it would be rejected. AÝ`Wm Bgo AñdrH¥$V H$a X|JoŸ&
Merits JwU
Following are the merits of certainty gQ>}ÝQ>r BpŠdd¡boÝQ> EàmoM Ho$ à_wI JwU {ZåZ-
equivalent approach: {b{IV h¢…

1. It is a simple method to understand. 1. Bg _oWS> H$mo g_PZm gab h¡Ÿ&
2. It incorporates risk by modifying the cash 2. BgHo$ AÝVJ©V CZ H¡$e âbmoO H$mo g§emo{YV {H$`m
flows which are subject to risk. Therefore, OmVm h¡ {OZHo$ gmW [añH$ Ow‹S>r hmoVr h¡Ÿ& Bg{bE `h
it is superior to the time adjusted discount Q>mB_ ES>OoñQ>oS> {S>ñH$mCÝQ> aoQ> EàmoM go ~ohVa h¡Ÿ&
rate approach.
Limitations gr_mE±
Following are some limitations of this ap- Bg EàmoM H$s Hw$N> gr_mE± ^r h¢, Omo {ZåZ{b{IV h¢…
proach:
1. The certainty equivalent coefficient is the 1. gQ>}ÝQ>r BpŠdd¡boÝQ> H$moB{\${eEÝQ> Bg EàmoM H$m
crucial element of this approach. These {ZUm©`H$ E{b_oÝQ> h¡Ÿ& `o H$moB{\${eEÝQ> {ZpíMV Am¡a
coefficients can not be precise and [ñWa Zht hmo gH$Vo Š`m|{H$ `o BÝdoñQ>g© H$s AdYmaUm