, PLEASE USE THIS DOCUMENT AS A GUIDE TO ANSWER YOUR ASSIGNMENT
QUESTION 1
1.1. Use the concept of risk and cash inflows to calculate the NPV and IRR relating to the
investment in project A.
Given:
Risk-free rate = 8%
Risk premium = 2%
Certainty equivalents (CE) are provided for each year.
Risk-adjusted rate for each year:
The risk-adjusted discount rate is calculated as the risk-free rate + risk premium. In this case, it’s:
Risk-adjusted rate = 8% + 2% = 10%
Step 1: Adjust cash flows using certainty equivalents
Project A has certainty equivalents for each year, adjust the nominal cash flows by multiplying them
with the corresponding certainty equivalents.
Adjusted Cash Flow=Cash Flow×Certainty Equivalent
Adjusted Cash Flows for Project A:
Year 0: 500,000 × 1.00 = 500 ,000
Year 1: 250,000 × 0.80 = 200,000
Year 2: 160,000 × 0.70 = 112,000
Year 3: 120,000 × 0.60 = 72,000
Year 4: 100,000 × 0.50 = 50,000
Year 5: 90,000 × 0.40 = 36,000
Step 2: Calculate the NPV
The NPV is calculated using the formula:
l-lPV- '°' CF1
L.., (1 - r )1
Where:
• C F1 is the adjusted cash flow at time t
• 1· is the discount rate (t0%)
• l is the year
Substituting the adjusted cash ffo\YS and applying the 10% discount rate:
QUESTION 1
1.1. Use the concept of risk and cash inflows to calculate the NPV and IRR relating to the
investment in project A.
Given:
Risk-free rate = 8%
Risk premium = 2%
Certainty equivalents (CE) are provided for each year.
Risk-adjusted rate for each year:
The risk-adjusted discount rate is calculated as the risk-free rate + risk premium. In this case, it’s:
Risk-adjusted rate = 8% + 2% = 10%
Step 1: Adjust cash flows using certainty equivalents
Project A has certainty equivalents for each year, adjust the nominal cash flows by multiplying them
with the corresponding certainty equivalents.
Adjusted Cash Flow=Cash Flow×Certainty Equivalent
Adjusted Cash Flows for Project A:
Year 0: 500,000 × 1.00 = 500 ,000
Year 1: 250,000 × 0.80 = 200,000
Year 2: 160,000 × 0.70 = 112,000
Year 3: 120,000 × 0.60 = 72,000
Year 4: 100,000 × 0.50 = 50,000
Year 5: 90,000 × 0.40 = 36,000
Step 2: Calculate the NPV
The NPV is calculated using the formula:
l-lPV- '°' CF1
L.., (1 - r )1
Where:
• C F1 is the adjusted cash flow at time t
• 1· is the discount rate (t0%)
• l is the year
Substituting the adjusted cash ffo\YS and applying the 10% discount rate:
