Describe how uncertainty is calculated into cash flows. Why should two projects with equal cash flows but unequal risks produce different financial results? Would you prefer a low-risk, low-return project or a high-risk, high-return project, and why?
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. The uncertainty is calculated in the cash flows by taking care of the risk factor. There are two approaches:
The certainty?equivalent approach recognizes risk in capital budgeting analysis by adjusting estimated cash flows and employs risk-free rate to discount the adjusted cash flows. On the other hand, the risk-adjusted discount rate adjusts for risk by adjusting the discount rate. It has been suggested that the ...
This solution of 409 words looks at the existence of risks in decision-making and describes how uncertainty is calculated into cash flows. It also discusses a preference of varying risk and returns as well as why equal cash flows can have different financial results.