In certainty equivalent approach, adjusted cash flows are discounted at :
Risk Free Rate
The certainty equivalent approach handles uncertainty in capital budgeting by adjusting the cash flows rather than the discount rate. Each expected cash flow is multiplied by a certainty equivalent coefficient α, where α = certain (riskless) cash flow ÷ risky expected cash flow, and 0 ≤ α ≤ 1.
Formula: \(NPV = \sum_{t=1}^{n} \dfrac{\alpha_t \, CF_t}{(1 + k_f)^t} - C_0\), where \(k_f\) is the risk-free rate.
Because the risk has already been removed from the cash flows, discounting them at a rate that again contains a risk premium (such as a hurdle rate or the cost of capital) would penalise the risk twice. Hence the certain cash flows are discounted at the risk-free rate.
The accounting rate of return is not a discount rate at all (it ignores the time value of money), and the internal rate of return is the result a project produces, not the rate used for discounting adjusted flows.
Hence, the answer is Risk Free Rate.
Similar Questions
Which of the following techniques for appraisal of investment proposals are based on time value of money ?
(a) Accounting Rate of Return
(b) Internal Rate of Return
(c) Profitability Index Method
(d) Earnings Per Share
Codes :
Which of the following is not true with reference to capital budgeting ?
In capital budgeting, the term capital rationing implies :
Interim cash inflows are reinvested at a rate of return equal to the internal rate of return is the built-in-mechanism for
Assertion (A) : When two or more investment proposals are mutually exclusive, ranking the proposals on the basis of IRR, NPV and PI methods may give contradictory results.
Reason (R) : The contradictory results in the ranking are due to differing dimensions relating to the scale of investments, cash flow patterns and project lives.
Indicate the correct answer :
Codes :
Match the items of the following two lists and suggest the correct code :
List – I List – II a. Pay-back Rate of Return i. Discounted Cash Flow Technique b. Internal Rate of Return ii. Compounded values of investments and returns c. Benefit Cost Ratio iii. Crude method for project evaluation d. Net Terminal Value Method iv. Varying sized projects evaluation Codes :
a b c d
Formula for net cash inflow of a project is :
Important Questions from Capital budgeting decisions
- Under which one of the following situation a firm can not raise capital for a project under any circumstance ?
- Which of the following statement about Finance lease is NOT true ?
(i) Finance lease transfer substantially all the risks and rewards incidental to ownership of an asset.
(ii) The lease period in a finance lease covers a substantial portion of the asset's economic life.
(iii) Payment towards lease rental in finance lease cover all cast incurred by lessor in obtaining the assets.
(iv) Finance lease is considered short-term in nature. - Assertion (A): Compounding interest allows an investment to grow faster over time compared to simple interest.
Reason (R): Simple interest earns interest on Previously earned interest. Which of the following variables is not known in Internal Rate of Return methods of capital budgeting?
- As per the Union Budget 2022, how many crore has been made to cover 3.8 crore households in 2022-23 under Har Ghar, Nal Se Jal Scheme?
