Accept-Reject Rule (Evaluation) Homework Help

EVALUATION

The certainty-equivalent approach has the merit of being simple to calculate. Another merit of this approach is that it incorporates risk by modifying the cash flows which are subjects risk. It is, therefore, conceptually superior to the time-adjusted discount rate approach.

Its weaknesses arise out of the practical problems of implementation. The crucial element application of this approach is the certainty-equivalent coefficient. It depends upon the preferences of the management and the perception of the investors. Being a subjective estimate cannot be objective, precise and consistent. The conclusions based on such an estimate would be open to question. Another weakness of this method is that it does not directly use the distribution of possible cash flows. Moreover, it is not as intuitively appealing as the risk adjusted discount rate approach and is more difficult to calculate as well as understand.

However, despite these shortcomings, the certainty-equivalent approach is theoretically superior the risk-adjusted discount rate approach. The reasons, in brief, are as follows. The risk adjusted discount rate method implies increasing risk over time when the discount rate, K, is constant. It will be the case that this assumption is appropriate. However, management is unable to increasing risk explicitly with this approach anti make serious errors in measuring risk over many projects, risk does increase with the length of time in future. As a result, the implicit in the risk-adjusted discount approach may well be valid. However, all projects necessarily confirm to this pattern. For example, an investment proposal may be more initial years, but when established it may not he that risky, for instance, a tree plantation. In which, the assumption of risk increasing with the length of time is not valid. This project would be penalized by the risk-adjusted discount rate approach. With the certainty-equivalent approach, management is able to specify directly the degree of risk for a particular future period and then discount the cash flow back to the present value. employing the time value of money. For this reason, the certainty-equivalent approach is superior to the risk-adjusted discounted rate method.

We have discussed so far two common techniques of handling risk in capital budgeting. They are at best crude attempts to incorporate risk. Their major shortcoming is that specifying the appropriate degree of risk for an investment project is beset with serious operational problems. Another common weakness of both these-methods is that they cannot be consistently applied to various projects and over time. A method to incorporate risk to the capital budgeting analysis should possess two attributes: (a) it should be able to specify in precise terms the appropriate degree of risk, and (b) these specifications should be consistently applied. The methods that satisfy these two requirements of a satisfactory approach are: (i) Probability Distribution Approach and (ii) Decision-tree Approach.

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