Question

5. A firm is considering a long-term investment project under risky environment. The following information is given about the project:

Time	0	1	2	3	4
CE Coefficient	1.0	0.95	0.92	0.89	0.85
Expected Cash Flows	-40000	10000	15000	17000	19000

The risk-free rate of return is 8%. The risk premium commensurate with the risk profile of the project is 5%. Will you advise the firm to accept this project using Certainty Equivalent approach? Will your suggestion differ, if you base your opinion on Risk Adjusted Discount Rate approach? Which approach will you prefer?

Answer 1

Time o certainty equivalent approach.- Reol Cash Expected cashflows CE coefficient Hous - 40000 - 40000 1.0 0.95 9500 10000 13800 15000 15130 0.89 17000 0.85 16150 19000 at d 0.92 m I Risk free rate = 87 using Risk free role to discount Real cash flows as Yisk is already adjusted through CE Cafficient. DCF/ NPV = -40000 + (1 9500x67.08)+13800X667) + 1530XC hog13) + 16150 X (107) - 4508.986 a) Risk Adjusted Discount rate approach:- Risk Adjusted Discount Yote - Risk free rate & Risk premium = 8.4 +5%. = 13-1 NPV = - 40000 +[10000 (1-15) + 15000*[CH3)2]+. 1700*[ct-53] + 90%(135-) = 4031.666 under both the options Npv' is positive it is ad visable to accept the project.