1.3 The variation in the discount factor reflects the investor attitude towards
risk. The higher the discount factor, the less attractive the project.
Therefore, higher rates will be used for riskier projects. The lower the
discount factor, the more attractive the project, but the returns will be
lower. Therefore lower rate will be used for less risky projects. An
investor becomes more and more negative with a project of higher
discount rate. This method shows only the degree of risk aversion.
Therefore, if IRR method is also used, an investor can clearly perceive the
risk of an investment project to accept or to reject.- Certainty Equivalent.
2.1 The estimates of cash flows should be reduced to some conservative level.
It is up to the investor to determine his best estimate of cash flow, with
Zero risk. Then the investor has to rise the estimate of returns and the
corresponding raise in the level of risk, will be called as certainty
equivalent coefficient. In other words, this co-efficient determines the
relationship between the certain cash flows and the risky cash flows. In
the certainty equivalent approach, the discount factor equal to risk-free
rate will be taken as base to adjust cash flow.2.2 The major point of risk is that it is an increasing function of time and
decreasing function of return. This will be the simple reality in most of
the situations. Exceptions may be there, where risk may be high until an
investment reaches a gestation point and risk may come down
substantially after the gestation period. In such kind of situation, certainty
equivalent approach has got a better application when compared to the
risk-adjusted discount rate.- Sensitivity Analysis
3.1 Anticipated revenue is a function of sales volume multiplied by the unit
selling price. The estimated cash flows depend on the expected revenue
and costs. The size of the market and share of the firm in a market decides
the size of the sales. The changes in costs and the taxes will influence the
estimated cash flows. It is very difficult to workout the correct
estimation under each variable influencing the cash flows. When the
basic estimation goes wrong the NPV or IRR forecasted figures will also
goes wrong. To determine reliability we have, at least 3 values for each of
the forecast.- Pessimistic
- Likely
- Optimistic
NPV or IRR is to be calculated for all these three assumptions.