The certainty equivalent approach to accounting for risk in capital budgeting involves
A)adjusting the discount rate used to calculate net present values.
B)adjusting the expected cash flows.
C)estimating the coefficient of variation.
D)estimating the standard deviation of the net present values.

Question

Quizplus · Accepted Answer

The certainty equivalent approach involves adjusting the expected cash flows to account for the level of risk involved with a particular investment. The adjustment is made such that the expected cash flows are adjusted to reflect the riskiness of the investment, and a risk-adjusted cash flow is arrived at. Other options, such as adjusting the discount rate or estimating the standard deviation, do not necessarily take into account the specific risk factors associated with the investment, and thus may not be as effective in accounting for risk. The coefficient of variation may be used to measure the level of variability in the cash flows, but it alone does not provide a definitive answer to adjusting for risk in a capital budgeting decision.

The Certainty Equivalent Approach to Accounting for Risk in Capital