Arihant CA
Arihant CA
Arihant CA
1
1.2
CHAPTER ONE
SCOPE & OBJECTIVE OF FINANCIAL MANAGEMENT
Q. 1 : Explain two basic functions of Financial Management.
1. Procurement of Funds:
Funds can be obtained from different sources having different characteristics in terms of risk, cost
and control. The funds raised from the issue of equity shares are the best from the risk point of view
since repayment is required only at the time of liquidation.
However, it is also the most costly source of finance due to dividend expectations of shareholders.
On the other hand, debentures are cheaper than equity shares due to their tax advantage.
However, they are usually riskier than equity shares. There are thus risk, cost and control
considerations which a finance manager must consider while procuring funds. The cost of funds
should be at the minimum level for that a proper balancing of risk and control factors must be
carried out.
2. Decision-making:
The chief focus of an accountant is to collect data and present the data while the financial
manager’s primary responsibility relates to financial planning, controlling and decision- making.
Thus, in a way it can be stated that financial management begins where financial accounting ends.
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1. Profit maximisation
Profit maximisation is a short-term objective and cannot be the sole objective of a company.
It is at best a limited objective.
If profit is given undue importance, a number of problems can arise like the term profit is vague,
profit maximisation has to be attempted with a realisation of risks involved, it does not take into
account the time pattern of returns and as an objective it is too narrow.
2. Wealth maximisation,
Wealth maximisation as an objective, means that the company is using its resources in a good
manner.
If the share value is to stay high, the company has to reduce its costs and use the resources properly.
If the company follows the goal of wealth maximisation, it means that the company will promote
only those policies that will lead to an efficient allocation of resources.
A firm’s financial management may often have the following as their objectives:
(i) The maximisation of firm’s profit.
(ii) The maximisation of firm’s value / wealth.
The maximisation of profit is often considered as an implied objective of a firm. To achieve the aforesaid
objective various type of financing decisions may be taken. Options resulting into maximisation of profit
may be selected by the firm’s decision makers. They even sometime may adopt policies yielding
exorbitant profits in short run which may prove to be unhealthy for the growth, survival and overall
interests of the firm. The profit of the firm in this case is measured in terms of its total accounting
profit available to its shareholders.
The value/wealth of a firm is defined as the market price of the firm’s stock. The market price of a
firm’s stock represents the focal judgment of all market participants as to what the value of the
particular firm is. It takes into account present and prospective future earnings per share, the timing
and risk of these earnings, the dividend policy of the firm and many other factors that bear upon the
market price of the stock.
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The value maximisation objective of a firm is superior to its profit maximisation objective due to
following reasons.
1. The value maximisation objective of a firm considers all future cash flows, dividends, earning per
share, risk of a decision etc. whereas profit maximisation objective does not consider the effect of
EPS, dividend paid or any other returns to shareholders or the wealth of the shareholder.
2. A firm that wishes to maximise the shareholders wealth may pay regular dividends whereas a firm
with the objective of profit maximisation may refrain from dividend payment to its shareholders.
3. Shareholders would prefer an increase in the firm’s wealth against its generation of increasing flow
of profits.
4. The market price of a share reflects the shareholders expected return, considering the long-term
prospects of the firm, reflects the differences in timings of the returns, considers risk and recognizes
the importance of distribution of returns.
The maximisation of a firm’s value as reflected in the market price of a share is viewed as a proper
goal of a firm. The profit maximisation can be considered as a part of the wealth maximisation strategy.
The knowledge requirements for the evolution of a Chief Finance Officer will extend from being aware
about capital productivity and cost of capital to human resources initiatives and competitive
environment analysis. He has to develop general management skills for a wider focus encompassing
all aspects of business that depend on or dictate finance.
1. Investment decision:
The investment of long term funds is made after a careful assessment of the various projects through
capital budgeting and uncertainty analysis. However, only that investment proposal is to be accepted
which is expected to yield at least so much return as is adequate to meet its cost of financing. This
have an influence on the profitability of the company and ultimately on its wealth.
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2. Financing decision:
Funds can be raised from various sources. Each source of funds involves different issues. The finance
manager has to maintain a proper balance between long-term and short-term funds. With the total
volume of long-term funds, he has to ensure a proper mix of loan funds and owner’s funds. The
optimum financing mix will increase return to equity shareholders and thus maximise their wealth.
3. Dividend decision:
The finance manager is also concerned with the decision to pay or declare dividend. He assists the top
management in deciding as to what portion of the profit should be paid to the shareholders by way of
dividends and what portion should be retained in the business. An optimal dividend pay-out ratio
maximises shareholders’ wealth.
The above discussion makes it clear that investment, financing and dividend decisions are interrelated
and are to be taken jointly keeping in view their joint effect on the shareholders’ wealth.
(a) Financial analysis and planning: Determining the proper amount of funds to be employed in the
firm.
(b) Investment decisions: Efficient allocation of funds to specific assets.
(c) Financial and capital structure decisions: Raising of funds on favourable terms as possible, i.e.,
determining the composition of liabilities.
(d) Management of financial resources (such as working capital).
(e) Risk Management: Protecting assets.
2. Financing decision
These decisions relate to acquiring the optimum finance to meet financial objectives and seeing that
fixed and working capital are effectively managed.
3. Dividend decision
These decisions relate to the determination as to how much and how frequently cash can be paid out
of the profits of an organisation as income for its owners/ shareholders. The owner of any profit-making
organization looks for reward for his investment in two ways, the growth of the capital invested and
the cash paid out as income; for a sole trader this income would be termed as drawings and for a
limited liability company the term is dividends.
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CHAPTER TWO
TYPES OF FINANCING
Q. 1 : What is debt securitisation? Explain the basics of debt
securitisation process.
Debt Securitisation:
It is a method of recycling of funds. It is especially beneficial to financial intermediaries to support the
lending volumes. Assets generating steady cash flows are packaged together and against this asset
pool, market securities can be issued, e.g. housing finance, auto loans, and credit card receivables.
4. Bridge Finance
Bridge finance refers, normally, to loans taken by the business, usually from commercial banks for a
short period, pending disbursement of term loans by financial
institutions, normally it takes time for the financial institution to finalise procedures of creation of
security, tie-up participation with other institutions etc. even though a positive appraisal of the project
has been made. However, once the loans are approved in principle, firms in order not to lose further
time in starting their projects arrange for bridge finance. Such temporary loan is normally repaid out
of the proceeds of the principal term loans. It is secured by hypothecation of moveable assets,
personal guarantees and demand promissory notes. Generally rate of interest on bridge finance is
higher as compared with that on term loans.
Meaning
Ploughing back of Profits or Retained earnings means retention of profit.
In other words, that part of surplus profit which is not distributed as dividend are termed as Retained
Profit or Ploughing back of Profits.
Features
Retained Earnings are an internal source of long term financing and are treated as long term funds.
Such funds belong to the ordinary shareholders and increase the net worth of the company.
A public limited company must plough back a reasonable amount of profit every year keeping in view
the legal requirements in this regard and its own expansion plans.
Such funds also entail almost no risk.
Further, control of present owners is also not diluted by retaining
profits.
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(iv) Since the risk involved in investing in the company is quite high, venture capitalists should ensure
that the prospects for future profits compensate for the risk.
(v) A research must be carried out to ensure that there is a market for the new product.
(vi) The venture capitalist himself should have the capacity to bear risk or loss, if the project fails.
(vii) The venture capitalist should try to establish a number of exist routes.
(viii) In case of companies, venture capitalist can seek for a place on the Board of Directors to have a say
on all significant matters affecting the business.
1. Equity financing
The venture capital undertakings generally requires funds for a longer period but may not be able to
provide returns to the investors during the initial stages.
Therefore, the venture capital finance is generally provided by way of equity share capital.
2. Conditional Loan
A conditional loan is repayable in the form of a royalty after the venture is able to generate sales.
No interest is paid on such loans.
In India, Venture Capital Financers charge royalty ranging between 2 to 15 per cent; actual rate
depends on other factors of the venture such as
gestation period,
cash flow patterns,
riskiness and
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3. Income Note
It is a hybrid security which combines the features of both conventional loan and conditional loan.
The entrepreneur has to pay both interest and royalty on sales but at substantially low rates.
4. Participating Debenture
Such security carries charges in three phases :
in the startup phase, no interest is charged,
next stage a low rate of interest is charged upto a particular level of operations,
after that, a high rate of interest is required to be paid.
1. Euro Bonds
These are the Bonds issued or traded in a country using a currency other than the one in which the
bond is denominated. These are issued by multinational corporations, for example, a British company
may issue a Eurobond in Germany, denominating it in U.S. dollars.
2. Floating Rate Notes
These are issued up to seven years maturity. Interest rates are adjusted to reflect the prevailing
exchange rates. They provide cheaper money than foreign loans.
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CHAPTER 3
COST OF CAPITAL
Q. 1 : What do you understand by Weighted Average Cost of
Capital?
Meaning
The composite or overall cost of capital of a firm is the weighted average of the costs of the various
sources of funds.
Weights are taken to be in the proportion of each source of fund in the capital structure.
While making financial decisions, this overall or weighted cost is used.
Each investment is financed from a pool of funds which represents the various sources from which
funds have been raised.
Any decision of investment, therefore, has to be made with reference to the overall cost of capital
and not with reference to the cost of a specific source of fund used in the investment decision.
Calculation
The weighted average cost of capital is calculated by :
Calculating the cost of specific source of fund e.g. cost of debt, equity etc;
Multiplying the cost of each source by its proportion in capital structure; and
Adding the weighted component cost to get the firm’s WACC represented by k0.
k0 = k1 w1 + k2 w2 + ………..
Where,
k1, k2 are component costs and w1, w2 are weights.
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CHAPTER - 4
LEVERAGE
Q. 1 : What do you understand by Business Risk and Financial
Risk?
1. Business Risk
Business risk refers to the risk associated with the firm’s operations.
It is an unavoidable risk because of the environment in which the firm has to operate and the
business risk is represented by the variability of earnings before interest and tax (EBIT).
The variability in turn is influenced by revenues and expenses.
Revenues and expenses are affected by demand of firm’s products, variations in prices and
proportion of fixed cost in total cost.
2. Financial Risk
Financial risk refers to the additional risk placed on firm’s shareholders as a result of debt use in
financing.
Companies that issue more debt instruments would have higher financial risk than companies
financed mostly by equity.
Financial risk can be measured by ratios such as firm’s financial
leverage multiplier, total debt to assets ratio etc.
Validity of statement
The statement is valid that “Operating risk is associated with cost structure whereas financial risk is
associated with capital structure of a business concern”.
Explanation
Operating risk refers to the risk associated with the firm’s operations.
It is represented by the variability of earnings before interest and tax (EBIT).
The variability in turn is influenced by revenues and expenses, which are affected by demand of firm’s
products, variations in prices and proportion of fixed cost in total cost.
If there is no fixed cost, there would be no operating risk.
Whereas financial risk refers to the additional risk placed on firm’s shareholders as a result of debt and
preference shares used in the capital structure of the concern.
Companies that issue more debt instruments would have higher financial risk than companies financed
mostly by equity.
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CHAPTER - 5
CAPITAL STRUCTURE
Q. 1 : What do you understand by Capital structure? How does it
differ from Financial structure?
1. Meaning of Capital Structure
Capital Structure refers to the combination of debt and equity which a company uses to finance its
long-term operations.
It is the permanent financing of the company representing long-term sources of capital i.e. owner’s
equity and long-term debts but excludes current liabilities.
2. Financial Structure
On the other hand, Financial Structure is the entire left-hand side of the balance sheet which represents
all the long-term and short-term sources of capital.
Thus, capital structure is only a part of financial structure.
1. Cost Principle
According to this principle, an ideal pattern or capital structure is one that
minimises cost of capital structure and
maximises earnings per share (EPS).
2. Risk Principle
According to this principle, reliance is placed more on common equity for financing capital
requirements than excessive use of debt.
Use of more and more debt means higher commitment in form of interest payout.
This would lead to erosion of shareholders value in unfavourable business situation.
3. Control Principle
While designing a capital structure, the finance manager may also keep in mind that existing
management control and ownership remains undisturbed.
4. Flexibility Principle
It means that the management chooses such a combination of sources of financing which it finds easier
to adjust according to changes in need of funds in future too.
5. Other Considerations
Besides above principles, other factors such as nature of industry, timing of issue and competition in
the industry should also be considered.
Causes
Raising more money through issue of shares or debentures than company can employ profitably.
Borrowing huge amount at higher rate than rate at which company can earn.
Excessive payment for the acquisition of fictitious assets such as goodwill etc.
Improper provision for depreciation, replacement of assets and distribution of dividends at a higher
rate.
Wrong estimation of earnings and capitalization.
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Consequences
Considerable reduction in the rate of dividend and interest payments.
Reduction in the market price of shares.
Resorting to “window dressing”.
Some companies may opt for reorganization. However, sometimes the matter gets worse and the
company may go into liquidation.
CHAPTER - 6
THEORIES OF CAPITAL STRUCTURE
Q. 1 : What is Net Operating income theory of capital structure?
Explain the assumptions on which the NOI theory is based.
Meaning
According to this approach, there is no relationship between the cost of capital and value of the firm.
The value of the firm is independent of the capital structure of the firm.
Assumptions
There are no taxes.
The market capitalizes the value of the firm as a whole. Thus, the split between debt and equity is not
important.
The increase in proportion of debt in capital structure leads to change in risk perception of the
shareholders i.e. increase in cost of equity (Ke). The increase in cost of equity is such as completely
offset the benefits of using cheaper debt.
The overall cost of capital remains same for all degrees of debt equity mix.
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CHAPTER - 7
INVESTMENT DECISIONS (CAPITAL BUDGETING)
Q. 1 : Explain the term Desirability factor.
In certain cases, we have to compare a number of proposals each involving different amount of cash
inflows.
One of the methods of comparing such proposals is to work out what is known as the ‘Desirability
factor’ or ‘Profitability index’.
Formula
Acceptance Criteria
A project is acceptable if its profitability index value is greater than 1.
1. Introduction
NPV and IRR methods differ in the sense that the results regarding the choice of an asset under certain
circumstances are mutually contradictory under two methods.
In case of mutually exclusive investment projects, in certain situations, they may give contradictory
results such that if the NPV method finds one proposal acceptable, IRR favours another.
2. Causes of difference
The different rankings given by NPV and IRR methods could be due to
Size disparity problem,
time disparity problem and
unequal expected lives.
Computation
This rate is to be found by trial and error method.
This rate is used in the evaluation of investment proposals.
In this method, the discount rate is not known but the cash outflows and cash inflows are known.
Relevance
In evaluating investment proposals, internal rate of return is compared with a required rate of return,
known as cut-off rate.
If it is more than cut-off rate the project is treated as acceptable; otherwise project is rejected.
Formula
1. Acceptance Criteria
A project is acceptable if its profitability index value is greater than 1.
2. Superiority
PI is known as a superior method of comparing a number of investment proposal than Net present
value method (NPV).
3. Limitations
Profitability index fails as a guide in resolving capital rationing where projects are indivisible.
Once a single large project with high NPV is selected, possibility of accepting several small projects
which together may have higher NPV than the single project is excluded.
Also, situations may arise where a project with a lower profitability index selected may generate cash
flows in such a way that another project can be taken up 1 or 2 years later, the total NPV in such case
being more than the one with a project with highest Profitability Index.
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CHAPTER - 8
ESTIMATION OF WORKING CAPITAL
Q. 1 : Discuss the estimation of working capital need based on
operating cycle process.
Meaning
One of the methods for forecasting working capital requirement is based on the concept of operating
cycle.
The determination of operating capital cycle helps in the forecast, control and management of working
capital.
The duration of working capital cycle may vary depending on the nature of the business.
Relevance
The length of operating cycle is the indicator of performance of management.
The net operating cycle represents the time interval for which the firm has to negotiate for Working
Capital from its Bankers.
It enables to determine accurately the amount of working capital needed for the continuous operation
of business activities.
Formula
In the form of an equation, the operating cycle process can be expressed as follows:
Operating Cycle = R + W + F +D – C
Where,
R = Raw material storage period
W = Work-in-progress holding period F = Finished goods storage period
D = Debtors collection period
C = Credit period availed
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CHAPTER - 9
DEBTOR’S MANAGEMENT
Q. 1 : Differentiate between Factoring and Bills discounting.
Basis Factoring Bill Discounting
Other name Factoring is called as “Invoice Bills discounting is known as ‘Invoice
Factoring”. discounting.”
Parties In Factoring, the parties are known as In Bills discounting, they are known as
the client, factor and debtor. drawer, drawee and payee.
Purpose Factoring is a sort of management of Bills discounting is a sort of borrowing
book debts. from commercial banks.
Relevant statute For factoring, there is no specific act. In the case of bills discounting, the
Negotiable Instruments Act is
applicable.
Meaning
In factoring, accounts receivables are generally sold to a financial institution (a subsidiary of commercial
bank-called “Factor”), who charges commission and bears the credit risks associated with the accounts
receivables purchased by it.
Its operation is very simple.
Clients enter into an agreement with the “factor” working out a factoring arrangement according to his
requirements.
The factor then takes the responsibility of monitoring, follow-up, collection and risk-taking and
provision of advance.
The factor generally fixes up a limit customer-wise for the client (seller).
Advantages
1. Convertibility
The biggest advantages of factoring are the immediate conversion of receivables into cash.
2. Reduction in Costs
Continuous factoring virtually eliminates the need for the credit department due to saving in collection
and administration cost.
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3. Certainty
Factoring ensures a definite pattern of cash inflows.
4. No feature of loan
There is no debt repayment, no compromise to balance sheet, no long term agreements or delays
associated with other methods of raising capital.
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CHAPTER - 10
TREASURY & CASH MANAGEMENT
When the cash balance reaches the upper limit, the transfer of cash equal to ‘h – z’ is invested in
marketable securities account.
When it touches the lower limit, a transfer from marketable securities account to cash account is made.
During the period, when cash balance stays between (h, z) and (z, 0) i.e. high and low limits, no
transactions between cash and marketable securities account is made.
The high and low limits of cash balance are set up on the basis of fixed cost associated with the securities
transaction, the opportunities cost of holding cash and degree of likely fluctuations in cash balances.
These limits satisfy the demands for cash at the lowest possible total costs.
Meaning
Virtual banking refers to the provision of banking and related services through the use of information
technology without direct recourse to the bank by the customer.
Advantages
Lower cost of handling a transaction.
The increased speed of response to customer requirements.
The lower cost of operating branch network along with reduced staff costs leads to cost efficiency.
Possibility of improved and a range of services being made available to the customer rapidly, accurately
and at his convenience.
1. Concentration Banking
In concentration banking, the company establishes a number of strategic collection centres in different
regions instead of a single collection centre at the head office.
This system reduces the period between the time a customer mails in his remittances and the time when
they become spendable funds with the company.
Payments received by the different collection centres are deposited with their respective local banks
which in turn transfer all surplus funds to the concentration bank of head office.
2. Mail Float
This is the time when a cheque is being processed by post office, messenger service or other means of
delivery.
1. Safety
Return and risks go hand in hand.
As the objective in this investment is ensuring liquidity, minimum risk is the criterion of selection.
2. Maturity
Matching of maturity and forecasted cash needs is essential.
Prices of long term securities fluctuate more with changes in interest rates and are therefore, more
risky.
3. Marketability
It refers to the convenience, speed and cost at which a security can be converted into cash.
If the security can be sold quickly without loss of time and price, it is highly liquid or marketable.
Towards this end, the treasury function may be divided into the following :
1. Cash
The efficient collection and payment of cash both inside the Management organisation and to third
parties is the function of treasury department.
Treasury normally manages surplus funds in an investment portfolio.
2. Currency Management
The treasury department manages the foreign currency risk exposure of the company.
It advises on the currency to be used when invoicing overseas sales.
It also manages any net exchange exposures in accordance with the company policy.
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3. Fund Management
Treasury department is responsible for planning and sourcing the company’s short, medium and long-
term cash needs.
It also participates in the decision on capital structure and forecasts future interest and foreign currency
rates.
4. Banking
Since short-term finance can come in the form of bank loans or through the sale of commercial paper
in the money market, therefore, treasury department carries out negotiations with bankers and acts as
the initial point of contact with them.
5. Corporate Finance
Treasury department is involved with both acquisition and disinvestment activities within the group.
In addition, it is often responsible for investor relations.
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CHAPTER - 11
WORKING CAPITAL FINANCE
Q. 1 : Enumerate the various forms of bank credit in financing
working capital of a business organization.
2. Overdraft
Under this facility, customers are allowed to withdraw in excess of credit balance standing in their
Current Account.
A fixed limit is therefore granted to the borrower within which the borrower is allowed to overdraw his
account.
3. Clean Overdrafts
Request for clean advances are entertained only from parties which are financially sound and reputed
for their integrity.
The bank has to rely upon the personal security of the borrowers.
4. Cash Credits
Cash Credit is an arrangement under which a customer is allowed an advance up to certain limit
against credit granted by bank.
Interest is not charged on the full amount of the advance but on the amount actually availed of by him.
An advance against the pledge of such documents is an advance against the pledge of goods
themselves.
A conservative policy means lower return and risk while an aggressive policy produces higher return
and risk.
The two important aims of the working capital management are profitability and solvency. A liquid firm
has less risk of insolvency i.e. it will hardly experience a cash shortage or a stock out situation.
However, there is a cost associated with maintaining a sound liquidity position.
So, to have a higher profitability the firm may have to sacrifice solvency and maintain a relatively low
level of current assets.
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1. Introduction
The financing of current assets involves a trade-off between risk and return.
A firm can choose from short or long term sources of finance.
Short term financing is less expensive than long term financing but at the same time, short term
financing involves greater risk than long term financing.
Depending on the mix of short term and long term financing, the approach followed by a company
may be referred as matching approach, conservative approach and aggressive approach.
2. Matching Approach
In matching approach, long-term finance is used to finance fixed assets and permanent current assets
and short term financing to finance temporary or variable current assets.
3. Conservative Approach
Under the conservative plan, the firm finances its permanent assets and also a part of temporary current
assets with long term financing and hence less risk of facing the problem of shortage of funds.
4. Aggressive Approach
An aggressive policy is said to be followed by the firm when it uses more short term financing than
warranted by the matching plan and finances a part of its permanent current assets with short term
financing.
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CHAPTER - 12
RATIO ANALYSIS
Q. 1 : Explain briefly the limitations of Financial ratios.
1. Diversified product lines
Many businesses operate a large number of divisions in quite different industries.
In such cases, ratios calculated on the basis of aggregate data cannot be used for inter-firm
comparisons.
3. Seasonal factors
Seasonal factors may also influence financial data.
4. Biased ratios
To give a good shape to the popularly used financial ratios (like current ratio, debt- equity ratios, etc.),
the business may make some year-end adjustments.
Such window dressing can change the character of financial ratios which would be different had there
been no such change.
CHAPTER - 13
RISK ANALYSIS IN CAPITAL BUDGETING
Q. 1 : What is certainty equivalent.
1. Definition
As per CIMA terminology, “An approach to dealing with risk in a capital budgeting context.
It involves expressing risky future cash flows in terms of the certain cashflow which would be considered,
by the decision maker, as their equivalent, that is the decision maker would be indifferent between the
risky amount and the (lower) riskless amount considered to be its equivalent.”
2. Mechanism
The certainty equivalent is a guaranteed return that the management would accept rather than
accepting a higher but uncertain return.
This approach allows the decision maker to incorporate his or her utility function into the analysis.
In this approach, a set of risk less cash flow is generated in place of the original cash flows.
3. Advantages
It is simple and easy to understand and apply.
It can easily be calculated for different risk levels applicable to different cash flows.
4. Disadvantages
There is no Statistical or Mathematical model available to estimate certainty Equivalent.
Certainty Equivalent are subjective and vary as per each individual’s estimate.
1. Opportunity Cost
There is an opportunity cost involved while investing in a project for the level of risk. Adjustment of risk
is necessary to help make the decision as to whether the returns out of the project are proportionate
with the risks borne and whether it is worth investing in the project over the other investment options
available.
2. Real Value
Risk adjustment is required to know the real value of the Cash Inflows.