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CS Professional · Strategic Management and Corporate Finance · Project Evaluation

In capital budgeting, the 'certainty equivalent' approach to adjusting for project risk works by:

The certainty equivalent approach multiplies each uncertain cash flow by a coefficient between zero and one to get an equivalent risk-free cash flow, which is then discounted at the risk-free rate. It adjusts the cash flows, not the discount rate.

  1. ARaising the discount rate by a risk premium while leaving cash flows unchanged
  2. BMultiplying each uncertain cash flow by a coefficient between 0 and 1 to convert it into an equivalent risk-free amount, then discounting at the risk-free rateCorrect
  3. CChanging one variable at a time to see its effect on NPV
  4. DAssigning probabilities to scenarios and computing the standard deviation of NPV

Explanation

The certainty equivalent method scales risky cash flows down by a coefficient (0 to 1) to obtain the amount management would accept with certainty, and then discounts at the risk-free rate. Raising the discount rate is the risk-adjusted discount rate method, which is why option A is wrong.

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