Comparable Riskless Flow
As already observed, the incorporation of risk in capital budgeting analysis is done, according to this approach by modifying the expected cash inflows. The first , therefore, involves the determination of the basis for modifying the cash flows to adjust for risk. The risk adjustment factor is expressed in terms of a certainty-equivalent coefficient. The certainty-equivalent coefficient represents the relationship between certain (riskless) cash flows and certain (risky) cash flows. Thus, the coefficient is equal to:
Investment decisions are associated with risk as the future returns are uncertain in the sense that actual returns are likely to vary from the estimates. If the returns could he made certain, there would be no element of risk. It can reasonably be expected that investors would prefer a relatively but certain cash flows rather than an uncertain, though slightly larger cash flow. How much they would accept would depend on their perception or utility preference with respect to risk. Therefore, depending on the perception the first step in the use of the certainty-equivalent approach is to as certain riskless cash flows comparable to the expected cash flows streams from the projects.
Suppose a project is expected to generate a cash flow amounting to Rs 20,000. Since this lines risk, a smaller but certain cash flow would be as acceptable to the firm as this one. Let us me that, on the basis of the utility preference of the management with respect to risk, the firm rank a certain cash flow of Rs 12.000 as equal to an uncertain cash flow of Rs 20.000. In words, the certainty-equivalent of Rs 20,000 is Rs 12,000. Or, the comparable risky flow for riskless flow of Rs 12,000 is Rs 20,000. Thus, the certainty equivalent coefficient is 0.60 (Rs 12,000 + Rs 20,000). This coefficient, when multiplied by the risky cash flow, would generate riskless cash flows, that is, 0.6 x Rs 20,000 = Rs 12,000.
The coefficient is a fractional amount which can assume a value between 0 and 1. There is an relationship between the degree of risk and the value of the coefficient; the higher the risk associated with the projected cash flow, the lower is the coefficient.