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Certainty equivalent net present value

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1. Certainty equivalents - Accept - reject decision
Pleasantville ball valve has constructed a table, shown below, that gives expected cash inflows and certainty equivalent factors for these cash inflows. These measures are for a new machine with a five-year life that requires an initial investment of $95,000. The firm has a 15 percent cost of capital, and the risk-free rate is 10 percent.

Year (t) Cash Inflows (CFt) Certainty equivalent factors (at)
1 $35,000 1
2 $35,000 0.8
3 $35,000 0.6
4 $35,000 0.6
5 $35,000 0.2

a.        What is the net present value (unadjusted for risk)?

b.        What is the certainty equivalent net present value?

c.        Should the firm accept the project? Explain why.

d.        Management has some doubts about the estimate of the certainty equivalent factor for year 5. There is some evidence that it may not be any lower than that for year 4. What impact might this have on the decision you recommended in C? Explain.

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