What is ‘Certainty Equivalent?’
The certainly equivalent is an approach to deal risks in a capital budgeting context, in which risky future cash flows are expressed in terms of the certain cash flows to make the reference for decision maker (between the risky amount and riskless (lower) amount).
Certainty Equivalent in daily Life
You are working in DB Bank and drawing a salary of $ 1,500 per month. If you ever get enough money to start a business, you would like to prefer to start a business for the higher return. For the decision of starting a business, the amount of your salary is your certainty equivalent.
Certainty Equivalent Cash Flow = Expected Cash Flow / (1+ Risk Premium)
Where risk premium is the excess of risk-adjusted discount rate over the risk-free rate.
Demerit of using Certainty Equivalent
The decision maker’s risk attitude towards investment is adjusted in the certainty equivalent method for converting the expected cash flows of the project into equivalent riskless amounts. The danger of using this method lies in the high level of subjective judgment required from the decision maker. For example, it is very difficult to assess whether a 90% factor or 80% factor should be applied.