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

Sundaram Textiles is evaluating a project costing ₹4,00,000 that is expected to give a single cash inflow of ₹6,00,000 at the end of year 1. Management assigns a certainty-equivalent coefficient of 0.80 to this inflow. The risk-free rate is 10%. Under the certainty-equivalent method, the NPV is closest to:

The NPV is about ₹36,364. The certainty-equivalent method first converts the risky inflow into a certain amount, 0.80 × ₹6,00,000 = ₹4,80,000, and then discounts it at the risk-free rate of 10%, giving ₹4,36,364. Subtracting the ₹4,00,000 outlay leaves ₹36,364.

  1. A₹1,45,455
  2. B₹36,364Correct
  3. C₹80,000
  4. D₹1,16,364

Explanation

Certain cash flow = 0.80 × 6,00,000 = ₹4,80,000. Discount it at the risk-free rate: 4,80,000/1.10 = ₹4,36,364. NPV = 4,36,364 − 4,00,000 = ₹36,364. Using the unadjusted ₹6,00,000 gives ₹1,45,455, which ignores the certainty-equivalent coefficient.

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