You are given risky cash flow data for a three-year project: Year Cas

You are given risky cash flow data for a three-year project:

Year Cash flow
1 $2,000
2 3,000
3 4,000

The initial cash outflow is $6,000; the risk-free interest rate is 6%, and the risk-adjusted discount rate is 10%.

Calculate the NPV by both the risk-adjusted discount rate method and the certainty equivalent method in such a way that the NPV will be the same using either method.

ANSWER

Riskless Risky
Cash Flow Cash Flow
CE Riskless Discounted Discounted
Year Cash Flow Factor* Cash Flow at 6% at 10%
1 2000 0.963636 1927 1818 1818
2 3000 0.928595 2786 2479 2479
3 4000 0.894828 3579 3005 3005

Total 7303 7303
Less initial investment 6000 6000
NPV 1303 1303

*CE factors:
1.06/1.1 = 0.963636
1.062/1.12 = 0.928595
1.063/1.13 = 0.894828