Application: Certainty Equivalence Assignment Help
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The Certainty Equivalent is a return that is absolute, and that which the investor will accept instead of taking risks. It is derived from the utility theory. In the CE method, the investor must first determine a cash flow’s risk and then evaluate how much profit, to be received with certainty, will make him or her impervious between risky and non-risky investments.
Risk prone cash flows are brought down as the more precarious the flows, the lower the CE values. Avail our Application: Certainty Equivalence Assignment help and get a better understanding of the topic.
An example of Certainty Equivalence:
- Situation 1:
Consider Flipping a fair coin. If it’s heads, you receive $2,00,00 million, if tails arrive, you are left empty handed. The expected value of the toss according to Probability is is (0.5)($2,000,000)+(0.5)($0) = $2,00,000, but the outcome actually will be either $0 or $1 million. So the choice is risk prone.
- Situation 2: No need to flip the coin and simply pocket $1,00,000 cash.
$1,00,000 is your certainty equivalent for this particular risky $2,00,000 expected cash flow. The riskless $1,00,000 thus provides the same utility as the risk prone $2,00,000 expected return on investment.
Application of Certainty Equivalence in Capital Budgeting Decisions
The Certainty Equivalence incorporates project risk into Capital Budgeting Decisions in the following ways:
- Estimation of the CE cash flow in every year based upon the expected cash flow and its risk factor.
- Given the CE’s, discount by the risk-free rate to obtain the project’s Net Present Value.
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Advantages and Disadvantages of Certainty Equivalence Method
- It is simple and precise.
- The CE method accounts for differential risk in cash flows.
- There is no practical way of determination of CE. Every person is entitled to their own estimate which varies significantly from person to person.
- Almost all CE’s reflect shareholder sentiments instead those on the management side.
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