3 alternative methods to adjust for risk an

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Unformatted text preview: jects can be treated as average risk. Moreover, the company cost of capital provide a good starting reference to evaluate project risk 6.3 Alternative methods to adjust for risk An alternative way to eliminate risk is to convert expected cash flows to certainty equivalents. A certainty equivalent is the (certain) cash flow which you are willing to swap an expected but uncertain cash flow for. The certain cash flow has exactly the same present value as an expected but uncertain cash flow. The certain cash flow is equal to (39) Certain cash flow PV ˜ (1  r ) Where PV is the present value of the uncertain cash flow and r is the interest rate. 6.4 Capital budgeting in practise Capital budgeting consists of two parts; 1) Estimate the cash flows, and 2) Estimate opportunity cost of capital. Thus, knowing which cash flows to include in the capital budgeting decision is as crucial as finding the right discount factor. Download free ebooks at bookboon.com 44 Corporate Finance Capital budgeting 6.4.1 What to discount? 1. Only cash flows are relevant - Cash flows are not accounting profits 2. Relevant cash flows are incremental - Include all incidental effects - Include the effect of imputa...
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This note was uploaded on 10/26/2012 for the course 19 19 taught by Professor - during the Spring '12 term at Sunway University College.

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