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CS Executive · Corporate Accounting and Financial Management · Capital Budgeting

In capital budgeting, the certainty-equivalent approach to handling risk works by:

The certainty-equivalent approach scales each uncertain cash flow down by a coefficient to obtain an equivalent riskless amount, and then discounts those adjusted flows at the risk-free rate. Risk is thus handled in the numerator, unlike the risk-adjusted discount rate method, which changes the denominator.

  1. ARaising the discount rate by a risk premium and leaving cash flows unchanged
  2. BConverting each risky cash flow into an assured cash flow using a certainty-equivalent coefficient, then discounting at the risk-free rateCorrect
  3. CShortening the payback period cut-off for risky projects
  4. DCalculating NPV under only the most optimistic cash flow estimates

Explanation

The certainty-equivalent method multiplies expected cash flows by a coefficient (between 0 and 1) to get the sure amount the manager would accept instead, and discounts these at the risk-free rate. Option A describes the risk-adjusted discount rate method, which adjusts the rate rather than the cash flows.

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