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Chapter 14

Example 1

Chances Plc are reviewing a project which involves a $2.5million investment
which will generate cash savings of $£875,000 per annum for 4 years. The
cost of capital for the project is 9%.

The directors believe that the cash savings at the end of year 1 are 90%
certain, in years 2 and 3 are 85% certain and for year 4 are 80% certain.

Required: Using certainty equivalents, calculate the NPV of the project.

Solution

Year Cash flow ($) Discount factor Certainty Present value
@ 9% equivalent ($)

0 (2,500,000) 1.000 1.00 (2,500,000)
1 875,000 0.917 0.90 722,138

2 875,000 0.842 0.85 626,238
3 875,000 0.772 0.85 574,175

4 875,000 0.708 0.80 495,600

Illustrations and further practice

Look at the illustrations in Chapter 14 on Certainty equivalents and try
TYU 6 – 8.

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