Page 161 - DMGT207_MANAGEMENT_OF_FINANCES

Management of Finances

Notes Advantages

1. It is simple to calculate.
2. It incorporates risk by modifying the cash flows, which are subject to risk.
3. Conceptually, it is superior to the time adjusted discount rate approach.

Weaknesses and Difficulties

1. Being a subjective estimate it cannot be objective, precise and consistent, hence conclusions
based on such estimates are open to question.
2. It does not directly use the probability distribution of possible cash flows.
3. It cannot be consistently applied to various projects and over time.

Example:

Cash outflows 1,50,000

Cash inflows Year 1 70,000
Year 2 90,000
Year 3 60,000
Riskless rate of return 9%

Risk adjusted rate of return for the current project 20%
Certainty equivalent coefficients for future cash inflows:
Year 1 0.90
Year 2 0.80

Year 3 0.65
Solution: NPV based on risk-adjusted rate of discount

+ +
= – 150,000 +

= – 150,000 + 58,333 + 62500 + 41667 = –150000 + 162500
= 12500, positive; hence project should be accepted
NPV based on certainty equivalent coefficient:

= – 150,000 + + +

= – 150000 + 57798 + 60601 + 30115
= – 150000 + 148514 = – 1486
= Negative; hence project should not be accepted.

Hence from the above illustration, it is clear that both the above methods may not yield identical
results.

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