Certainty-Equivalent Approach

Unlike the RAD rate approach which adjusted the discount rate, this approach adjusts the expected cash flows. The risk-adjustment factor is expressed through a certainty- equivalence coefficient (CEC). 

CEC is given by ,

                         Certain, or risk less, cash flow 

         CEC = -----------------------------------

                                Risky cash flow 

On the one hand, the future.returns are subject to risk and might vary from the estimates made at the time of appraisal; on the other hand, if the returns could be made certain, there will be no element of risk. With this concept as a background, this approach begins with ascertaining the risk less cash flows comparable to the expected (i.e. subject to risk) cash flows from the project. 

Let the expected cash flow in a particular future year be Rs. 50,000. Considering the risk involved in it, the risk perception continuing to be only subjective at the firms  level, let it be said that the management, based on its utility preferences for that year in future, would be willing to accept (or consider) Rs. 35,000 as a certain cash flow, i.e. if Rs. 35,000 can be the cash flow with total certainty. (This is like a bettor in a lottery saying that he would rather like to be assured of Rs. 35,000 in that year than expecting Rs. 50,000 with the associated risk perception.) Then, Rs. 35,000 is the certainty equivalent of Rs. 50,000 for that future year, and the CEC is  35,000 /50,000 = 0.70.                                        

Admittedly, CEC values can range from 0.00 to 1.00. The higher the risk, the lower the coefficient. 

The certainty equivalent is used in the computation of NPV together with the risk-free required rate of return. Beyond this, computations proceed in the normal course. Acceptance criteria continue to be the same as in normal course of computations. 

Besides being simple in methodology, the method incorporates management's  perception, on a year-to-year basis in the future, adjusting the element subject to risk, viz. the cash flow and not the discount rate. The subjective element in deciding the certainty equivalent is the source of drawback in this method. Yet, certainty equivalent provides for varying risks over the years in future. Though this method is also crude in its outline, it is considered better than RAD rate method.