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Certainty Equivalent Method

The V. Coles Corp. is considering two mutually exclusive projects. The expected values for each project's cash flows are as follows:

Year Project A Project B
0 ($1,000,000) ($1,000,000)
1 500,000 500,000
2 700,000 600,000
3 600,000 700,000
4 500,000 800,000

Management has decided to evaluate these projects using the certainty equivalent method. The certainty equivalent coefficients for each project's each cash flows are as follows:

Year Project A Project B
0 1.00 1.00
1 0.95 0.90
2 0.90 0.70
3 0.80 0.60
4 0.70 0.50

Given that this company's normal required rate of return is 15 percent and the after-tax-free rate is 5 percent, which project should be selected?

Solution Preview

Please refer attached file for better clarity of tables.

Project A

Risk Free Rate=r=5%

Year End Cash Flow Coefficient* Certain Cash Flow PV
n C b C*b C*b/(1+r)^n
0 -1,000,000.00 1.00 -1,000,000.00 -1,000,000.00
1 500,000.00 0.95 475,000.00 ...

Solution Summary

Solution describes the steps to select a better based upon certainty equivalent method.

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