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Unformatted text preview: W E B E X T E N S I O N 11A Certainty Equivalents and RiskAdjusted Discount Rates T wo alternative methods have been developed for incorporating project risk into the capital budgeting decision process. One is the certainty equivalent method , in which the expected cash flows are adjusted to reflect project risk: Risky cash flows are scaled down because the riskier the flows, the lower their certainty equivalent values. The second is the riskadjusted discount rate method , where differ ential project risk is dealt with by changing the discount rate: Averagerisk projects are discounted at the firm s corporate cost of capital, aboveaveragerisk projects are discounted at a higher cost of capital, and belowaveragerisk projects are discounted at a rate below the corporate cost of capital. The riskadjusted discount rate method is used by most companies, so we focused on it in earlier chapters. However, the certainty equiv alent approach does have some advantages, so financial managers should be familiar with it as well. It is not always possible to find existing models for financial options that corre spond to all real options. In such a situation, the analyst must use financial engineer ing techniques. One technique, riskneutral valuation , is analogous to the certainty equivalent method, except it is applied using simulation. 11.1 T HE C ERTAINTY E QUIVALENT M ETHOD The certainty equivalent (CE) method follows directly from the concept of utility theory. Under the CE approach, the decision maker must first evaluate a cash flow s risk and then specify how much money, to be received with certainty, will make him indifferent between the riskless and the risky cash flows. To illustrate, suppose a rich eccentric offered you the following two choices: 1. Flip a fair coin. If heads comes up you receive $1 million, but if tails comes up you get nothing. The expected value of the gamble is (0.5)($1,000,000) + (0.5)($0) = $500,000, but the actual outcome will be either $0 or $1 million, so this choice is risky. 2. Do not flip the coin and simply pocket $300,000 cash. If you find yourself indifferent between the two alternatives, then $300,000 is your certainty equivalent for this particular risky $500,000 expected cash flow. The certain (or riskless) $300,000 thus provides you with the same utility as the risky $500,000 expected return. Now ask yourself this question: In the preceding example, exactly how much cash inhand would it actually take to make you indifferent between a certain sum and the risky $500,000 expected return? If you are like most people, your certainty equivalent would be significantly less than $500,000, indicating that you are risk averse. In 1 general, people are risk averse, and the lower the certainty equivalent, the greater the decision maker s risk aversion....
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This note was uploaded on 05/03/2010 for the course FRR 3032 taught by Professor Mr.wroshr during the Spring '10 term at Crafton Hills College.
 Spring '10
 MR.Wroshr

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