# Calculate the Certainty Equivalent Cash Flows and NPV

Scenario:

The Board liked an analysis you did on valuation and agreed to proceed with the expansion plan. Your CFO, investment bankers, and consultants have all been working on the cost and benefits of various expansion options. They have agreed on an option that will see simultaneous expansion into 5 domestic markets (Chicago, Dallas, Miami, New York, and Charlotte), Germany, and Brazil. The CFO has developed cost and benefits of the scenario in a spreadsheet and has asked you to review it.

Look at the spreadsheet attached and use present value analysis to discount the cash flows. Determine if the project is a net positive or negative impact on the firm, NPV. Calculate the certainty equivalent cash flows and NPV. What kind of questions would you ask the CEO about economic assumptions? Articulate the economic and political risk with the strategy and list options to overcome. Should this approach to expansion be adopted? (Answer using CE cash flows and non-CE cash flows.)

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#### Solution Preview

The investment decisions of a firm are generally known as the capital budgeting, or capital expenditure decisions. The firm's investment decisions would generally include expansion, acquisition, modernization and replacement of the long-term assets. Sale of a division or business (divestment) is also as an investment decision.

Criteria of selection of Capital Budgeting project:

It should maximize the shareholders' wealth.

It should consider all cash flows to determine the true profitability of the project.

It should provide for an objective and unambiguous way of separating good projects from bad projects.

It should help ranking of projects according to their true profitability.

It should recognize the fact that bigger cash flows are preferable to smaller ones and early cash flows are preferable to later ones.

It should help to choose among mutually exclusive projects that project which maximizes the shareholders' wealth.

It should be a criterion, which is applicable to any conceivable investment project independent of others.

(Pandey, I.M.)

Concept of Risk

Yes we incorporate risk in the capital budgeting.

Risk exists because of the inability of the decision-maker to make perfect forecasts. In formal terms, the risk associated with an investment may be defined as the variability that is likely to occur in the future returns from the investment.

(Pandey, I.M.)

Three broad categories of the events influencing the investment forecasts:

General economic conditions

Industry factors

Company factors

Two techniques are used to incorporate risk:

1. Certainty equivalent cash flow approach

2. Risk adjusted discount rate

The following are the advantages of the certainty equivalent cash flow approach

Reduce the forecasts of cash flows to some conservative levels.

The certainty-equivalent coefficient assumes a value between 0 and 1, and varies inversely with risk.

Decision-maker subjectively or objectively establishes the coefficients.

The certainty-equivalent coefficient can be determined as a relationship between the certain cash flows and the risky cash flows.

The following are the advantages of risk-adjusted discount rate method:

It is simple and can be easily understood.

It has a great deal of intuitive appeal for risk-averse businessman.

It incorporates an attitude (risk-aversion) towards uncertainty.

This approach, however, suffers from the following limitations:

There is no easy way of deriving a risk-adjusted discount rate. As discussed earlier, CAPM provides for a basis of calculating the risk-adjusted discount rate. Its use has yet to pick up in practice.

It does not make any risk adjustment in the numerator for the cash flows that are forecast over the future years.

It is based on the assumption that investors are risk-averse. Though it is generally true, there exists a category of risk seekers who do not demand premium for assuming risks; they are willing to pay a premium to take risks.

The certainty-equivalent approach recognizes risk in capital budgeting analysis by adjusting estimated ...

#### Solution Summary

The solution is 1833 words and gives both the required analysis and report on economic and political risk and NPV with many references. The calculations are attached in Excel.