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Cost of capital and capital investment decisions

Certainty equivalents

3.1 Method

1. The cash flows of the project are estimated / calculated as per normal

2. Cash flows are adjusted downwards by multiplying by a certainty equivalent
factor. This in effect decreases the cash flow to reflect the level of uncertainty.

3. The cash flows are then discounted at the risk free rate.

Benefits of using certainty equivalents

 They are a very simple way of incorporating risk into an investment appraisal.

 They enable the decision maker to reduce the possible future cash flows to give
a worst possible scenario NPV.

 By using a risk-free rate for discounting, they avoid double counting risk.

 Avoids the need to estimate an appropriate discount rate which reflects the risk.

 The certainty equivalent approach distinguishes between risk and time.

 In practice the major problem is that the use of certainty equivalents is
subjective.

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