Another procedure by which to evaluate project risk is the certainty equivalent approach. Under this approach, a projects expected future cash flows are adjusted from their forecastedand generally riskyvalues to their equivalent certain, or guaranteed, values. Thus, each certainty equivalent cash flow represents a risk-free cash flow that the decision-maker considers to be equal to the riskier cash flow.

Consider the case of the Fantasy Aeronautics:

The company has forecasted cash flows expected from a planned investment project. Considering its uncertain economic conditions, the firms managers want to adjust the projects risk and then estimate its net present value (NPV) using the certainty equivalent factor approach. Youve been assigned to complete this analysis.

Using the data available to you in the following table, complete the certainty equivalent analysis for the project. Use 6% as the tax-adjusted risk-free rate in your analysis. Remember, the firms cost of capital reflects the average riskiness of the company, and using the firms cost of capital in your analysis would lead to a double counting of the projects risk.

Fantasy Aeronautics: Calculation of Certainty Equivalent Net Present Value
Year	Expected NCF	Certainty Equivalent Factor ()	Certainty Equivalent Cash Flow	Present Value of Cash Flows
0	$36,000	1.00	-$36,000	-$36,000
1	$32,400	0.85
2	$28,800	0.70
3	$27,000	0.55
4	$23,400	0.40
				True or False: The certainty equivalent method can easily accommodate differential risk among cash flows. False True