DKA uses the certainty equivalent approach to deal with total project risk and is considering a project with the following: $$\begin{array} { l l l }
\text { Year } & \text { Expec. NCF } & \text { Certainty Equivalent Factor } \
0 & - \$ 60,000 & 1.0 \
1 & \$ 20,000 & 0.95 \
2 & \$ 20,000 & 0.90 \
3 & \$ 25,000 & 0.80 \
4 & \$ 30,000 & 0.65
\end{array}$$ ? What is the certainty equivalent NPV for this project if the risk-free rate is 8% and the required return on the market portfolio is 15%?
A) $3,233
B) $17,743
C) -$15,243
D) $13,233

Question

DKA uses the certainty equivalent approach to deal with total project risk and is considering a project with the following: $$\begin{array} { l l l } 
\text { Year } & \text { Expec. NCF } & \text { Certainty Equivalent Factor } \
0 & - \$ 60,000 & 1.0 \
1 & \$ 20,000 & 0.95 \
2 & \$ 20,000 & 0.90 \
3 & \$ 25,000 & 0.80 \
4 & \$ 30,000 & 0.65
\end{array}$$ ? What is the certainty equivalent NPV for this project if the risk-free rate is 8% and the required return on the market portfolio is 15%?
A) $3,233
B) $17,743
C) -$15,243
D) $13,233

Quizplus · Accepted Answer

The certainty equivalent NPV is calculated by adjusting the expected cash flows with the certainty equivalent factors and then discounting them at the risk-free rate. The calculation is as follows:  Year 0: -$60,000 * 1.0 = -$60,000  Year 1: $20,000 * 0.95 / (1 + 0.08)^1 = $17,593  Year 2: $20,000 * 0.90 / (1 + 0.08)^2 = $15,385  Year 3: $25,000 * 0.80 / (1 + 0.08)^3 = $15,873  Year 4: $30,000 * 0.65 / (1 + 0.08)^4 = $19,382  Summing these gives the certainty equivalent NPV: -$60,000 + $17,593 + $15,385 + $15,873 + $19,382 = $3,233.

DKA Uses the Certainty Equivalent Approach to Deal with Total