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 $173,000 project provides the following inflows with the associated coefficients of variation for each year.

Year Inflow Coefficient of Variation 1 $ 39,600 0.11 2 56,500 0.24 3 79,700 0.55 4 61,700 0.79 5 61,700 1.04 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.)

b-1. If the risk-free rate is 6 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.)

b-2. Should this project be accepted?

No Yes References

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 Adjustment Variation Factor 0 -0.25 0.90 II 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 $173,000 project provides the following inflows with the associated coefficients of variation for each year. Coefficient of Variation Year Inflow $39,600 0.11 56,500 0.24 79,700 0.55 61,700 0.79 5 61,700 1.04 Use Appendix B for an approximate answer but calculate your final answer using the formula and financial calculator methods