Problem 13-25 Certainty equivalent approach [LO13-1]

Sheila Goodman recently received her MBA from the Harvard Business School. She has joined the family business, Goodman Software Products Inc., as Vice-President of Finance. She believes in adjusting projects for risk. Her father is somewhat skeptical but agrees to go along with her. Her approach is somewhat different than the risk-adjusted discount rate approach, but achieves the same objective. She suggests that the inflows for each year of a project be adjusted downward for lack of certainty and then be discounted back at a risk-free rate. The theory is that the adjustment penalty makes the inflows the equivalent of riskless inflows, and therefore a risk-free rate is justified.

A table showing the possible coefficient of variation for an inflow and the associated adjustment factor is shown next:

Coefficient of Variation			Adjustment Factor
0	−	0.25		0.90
0.26	−	0.50		0.80
0.51	−	0.75		0.70
0.76	−	1.00		0.60
1.01	−	1.25		0.50

Assume a $175,000 project provides the following inflows with the associated coefficients of variation for each year.

Year	Inflow		Coefficient of Variation
1	$	33,900			0.15
2		50,800			0.28
3		70,200			0.42
4		62,200			0.80
5		60,900			1.13

Use Appendix B for an approximate answer but calculate your final answer using the formula and financial calculator methods.

a. Fill in the table below: (Do not round intermediate calculations. Round "Adjustment Factor" answers to 2 decimal places and other answers to the nearest whole dollar.)

YEAR	ADJUSTEMENT FACTOR	ADJUSTED INFLOW
1
2
3
4
5

b-1. If the risk-free rate is 7 percent, compute the net present value of the adjusted inflows. (Negative amount should be indicated by a minus sign. Do not round intermediate calculations and round your answer to 2 decimal places.)

Net present value :

b-2. Should this project be accepted?

multiple choice

• Yes

• No