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

Shree Textiles is evaluating a project with an initial outlay of Rs 50 lakh. Its expected annual cash inflow is Rs 20 lakh for 3 years under a risk-free scenario. The firm uses a certainty equivalent coefficient of 0.80 for all years, and the risk-free rate is 10%. The PV annuity factor at 10% for 3 years is 2.487. What is the NPV using the certainty equivalent approach?

The NPV is Rs -10.208 lakh. Each year's cash flow is reduced to its certain equivalent of Rs 16 lakh (20 x 0.80), discounted at the risk-free rate using the annuity factor 2.487 to get Rs 39.792 lakh, and the Rs 50 lakh outlay is subtracted.

  1. ARs -10.208 lakhCorrect
  2. BRs -0.208 lakh
  3. CRs 9.740 lakh
  4. DRs -2.208 lakh

Explanation

Certainty equivalent cash flow = 20 x 0.80 = 16 lakh per year. PV = 16 x 2.487 = 39.792 lakh. NPV = 39.792 - 50 = -10.208 lakh. Rs 9.740 lakh is wrong because it discounts the uncertain flows 20 x 2.487 = 49.74 and then subtracts 40 instead of 50 (outlay mistake). Rs -0.208 lakh comes from using the unadjusted flows (49.74 - 50 = -0.26), so not the answer either.

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