What are the similarities and differences between the risk-adjusted discount rate and the certainty equivalent methods for incorporating risk into the capital-budgeting?

Answer 1

The primary difference between the certainty equivalent approach and the risk-adjusted

discount rate approach is where the adjustment for risk is incorporated into the

calculations. The certainty equivalent approach penalizes or adjusts downwards the

value of the expected annual free cash flows, while the risk-adjusted discount rate

leaves the cash flows at their expected value and adjusts the required rate of return, k,

upwards to compensate for added risk. In either case the net present value of the

project is being adjusted downwards to compensate for additional risk. An additional

difference between these methods is that the risk-adjusted discount rate assumes that

risk increases over time and that cash flows occurring later in the future should be

more severely penalized. The certainty equivalent method, on the other hand, allows

each cash flow to be treated individually.