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Forums › Ask CIMA Tutor Forums › Ask CIMA P3 Tutor Forums › Calculating certainity equivalent.
B has an opportunity to invest $90000 on a project expected to generate cash inflows of $60000 for each of the next 3 years. Projects beta coefficient implies a discount rate of 12% for this project based on a risk free rate of return of 3%.
B is prepared to forego the expected cash flows from this project in return for a guaranteed payment of $50000 at end of year 1, $42000 at the end of year 2, $32000 at end of year 3.
What is the certainity equivalent value of this opportunity to B.?
Answer is $25,606.
Can you please do the working calculation to arrive at this?
Certainty equivalents mean that there is no risk so the risk free discount rate must be used. (Risk is eliminated by reducing the raw flows to their ‘certain’ equivalents.)
So
50000/1.03 + 42,000/1.03^2 + 32,000/1.03^3 – 90,000 = 27,418
I think the model answer is wrong (or you have mis-typed something!)