Q. Describes the Certainty Equivalent Coefficient Method?
Introduction: - Certainty equivalent coefficient process which makes adjustment against risk in the estimates of future cash inflows for a hazardous capital investment project.
In this process adjustment against risk is made in the estimates of future cash inflows of a risky capital project by adjusting to a conformist level of the estimated cash flows of a capital investment proposal by applying a correlation factor termed as certainty equivalent coefficient.
Formula for Computing Certainty Equivalent Coefficient: - The certainty equal coefficient is the ratio of riskless cash flow to risky cash flow. The certainty equal coefficient can be calculated with the help of the following formula:
Certainty Equivalent Coefficient = Riskless Cash Flow / Risky Cash Flow
(1) Riskless Cash Flow: - Riskless cash flow signifies the cash flow which the management expects when there is no risk in investment proposal.
(2) Risky Cash Flow: - Risky cash flow signifies the cash flow which the management expects when there is risk in investment proposal.