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

Meenakshi Textiles is evaluating a project whose cash flows are uncertain. Its normal required return is 12% and the project is judged under the certainty equivalent approach. Year 1 expected cash flow is Rs 5,00,000 with a certainty equivalent coefficient of 0.80. The risk-free rate is 8%. Initial outlay is Rs 3,50,000 and the project lasts one year only. What is the NPV using the certainty equivalent method?

Under the certainty equivalent method the cash flow is first scaled by the coefficient to Rs 4,00,000 and then discounted at the risk-free rate of 8%, giving Rs 3,70,370. Subtracting the outlay of Rs 3,50,000 gives an NPV of about Rs 20,370.

  1. ARs 7,143
  2. BRs 20,370 (approximately)Correct
  3. CRs 57,143
  4. DRs 1,50,000

Explanation

Certainty equivalent cash flow = 5,00,000 x 0.80 = 4,00,000. It is discounted at the risk-free rate of 8%: 4,00,000/1.08 = 3,70,370. NPV = 3,70,370 - 3,50,000 = 20,370. Discounting at 12% gives 3,57,143, NPV 7,143, which is the wrong rate.

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