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CMA Final · Strategic Financial Management · Evaluation of Risky Proposals for Investment Decisions

A project costs Rs 1,00,000 now and gives a certain-equivalent cash flow of Rs 60,000 at the end of each of the next 2 years. The risk-free rate is 8%. Using the certainty equivalent approach, what is the NPV (approximately)?

The NPV is approximately Rs 7,000. Certainty-equivalent cash flows are discounted at the risk-free rate, not a risk-adjusted rate. The two-year annuity factor at 8% is 1.7833, so present value is about Rs 1,07,000, and subtracting the Rs 1,00,000 outlay leaves roughly Rs 7,000.

  1. ARs 7,000
  2. BRs 3,000
  3. CRs 10,700Correct
  4. DRs 20,000

Explanation

Discount the certainty-equivalent flows at the risk-free rate: annuity factor for 2 years at 8% = 0.9259 + 0.8573 = 1.7833. PV = 60,000 x 1.7833 = 1,06,998, so NPV is about Rs 6,998 ... recomputing: 1,06,998 - 1,00,000 = Rs 6,998, approximately Rs 7,000.

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