162 Financial Management
Replacement investments Expansion investments New product investments Research
and development investments.
The certainty equivalent method is conceptually superior to the risk-adjusted discount
rate method because it does not assume that risk increases with time at a constant rate.
Each yearís certainty equivalent coefficient is based on the level of risk characterising
its cash flow. Despite its conceptual soundness it is not as popular as the risk-adjusted
discount rate method. This is perhaps because it is inconvenient and difficult to specify
a series of certainty equivalent coefficient but seemingly simply to adjust the discount
rate. Notwithstanding this practical difficulty, the merits of the certainty equivalent
method must not be ignored.Analysis of Non Financial Aspects
Investment decisions are based on appraisal and evaluation techniques. Apart from
technical and financial viability the project's economic and socio-political costs also
matter.Economic Aspects
Institutions and banks consider various economic factors before deciding to invest in a
project. Various analytical tools exist to assist the decision maker in dealing with this
situation. Among these tools are: cost-benefit analysis, risk-benefit analysis, risk-cost
benefit analysis, project economic viability, opportunity cost and insurability limits. It is
not suggested that these methods give exact results, but only that they reveal something
of the nature of the underlying valuation.
For a completely satisfactory assessment of the cost and benefit aspects of the
acceptability of risk, the assessment has to include evaluation of the following:- The total costs associated with each option.
- The benefits in money terms associated with each option. It must be recognised
that, at least initially, all the benefits may not be expressed directly in quantitative
terms and there may be problems in converting qualitative statements about benefits
into quantitative statements. - The costs in quantitative terms associated with the direct and indirect risks inherent
in each option. - The errors and uncertainties associated with the estimates of costs and benefits.
- The overall economic implications of the options considered.
Given the doubts about the feasibility of finding universal criteria for assessing the
ranking that economic factors justify, it is suggested that for many cases ranking of
acceptability of the economic factors could be made on the basis of the life cost and
benefits, the calculation taking into account all direct and indirect costs and benefits. It