In this chapter, risk is accounted for by (1) applying a discount rate commensurate with the riskiness of the cash flows, and (2), by using a certainty equivalent factor
In chapter 8, risk is accounted for by evaluating the project using sensitivity and breakeven analysis.
The ideal investment decision making technique is Net Present Value.
N P V measures the equivalent present wealth contributed by the investment.
NPV is given in
NPV -- relates directly to the firm’s goal of wealth maximization
-- employs the time value of money
-- can be used in all types of investments
-- can be adjusted to incorporate risk.
The third approach, modern capital budgeting, recognises that today’s (present) value
of an investment asset is the cash flow it can generate in the future, not the returns it has
provided in the past. Accordingly, investment appraisal must adopt an ‘ex ante’ - forward-
looking analysis - as distinct from the backward-looking focus of the traditional financial
approaches typified by the ROI calculation.