The present value of risky cash flows is calculated as follows:
I. estimate the expected cash flows and discount these at a rate that is consistent with the risk of the cash flows
II. estimate the certainty-equivalent cash flows and discount these at the risk-free rate
III. estimate the expected cash flows and discount these at the risk-free rate

Question

Quizplus · Accepted Answer

The present value of risky cash flows is calculated by estimating the expected cash flows and discounting them at a rate that is consistent with the risk of the cash flows (I), or by estimating the certainty-equivalent cash flows and discounting them at the risk-free rate (II). By combining these two methods, we can calculate a range of possible present values, which would provide a more accurate estimate of the present value of the risky cash flows. Therefore, both options I and II are necessary to accurately calculate the present value of risky cash flows. Option III is not a valid method of calculating the present value of risky cash flows because it does not take into account the risk of the cash flows.

The Present Value of Risky Cash Flows Is Calculated as Follows