Asked by Guillermo Orizaba on May 05, 2024
Verified
Which of the following is the appropriate discount rate to be used when calculating NPV in the certainty equivalent approach?
A) Cost of capital
B) Risk-free rate
C) Cost of equity
D) Market risk premium
Risk-Free Rate
The theoretical return on investment with no risk of financial loss, typically represented by the yield on government securities.
Certainty Equivalent Approach
The Certainty Equivalent Approach is a method used in finance to evaluate investments by adjusting uncertain future cash flows to their guaranteed amounts.
- Gain an understanding of the certainty equivalent technique and how it's applied in the adjustment of cash flows for risk considerations.
- Determine the suitable discount rate for various projects, considering their risk assessments.
Verified Answer
JS
Justin SmithMay 07, 2024
Final Answer :
B
Explanation :
The appropriate discount rate to be used when calculating NPV in the certainty equivalent approach is the risk-free rate. This is because the certainty equivalent approach assumes that the cash flows are risk-free and the risk premium is already included in the cash flows. Therefore, the risk-free rate is used as the discount rate to reflect the time value of money.
Learning Objectives
- Gain an understanding of the certainty equivalent technique and how it's applied in the adjustment of cash flows for risk considerations.
- Determine the suitable discount rate for various projects, considering their risk assessments.
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