Original Research

Certainty equivalent coefficients and capital budgeting: A caveat

S. Paulo
South African Journal of Business Management | Vol 24, No 4 | a874 | DOI: https://doi.org/10.4102/sajbm.v24i4.874 | © 2018 S. Paulo | This work is licensed under CC Attribution 4.0
Submitted: 17 October 2018 | Published: 31 December 1993

About the author(s)

S. Paulo, Department of Business Economics, University of Port Elizabeth, South Africa

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Abstract

The purpose of this technical note is to draw attention to the problems which are inherent in the use of certainty equivalent coefficients as an approach to incorporating risk into capital budgeting. More specifically, the certainty equivalent coefficient net present value criterion violates an important principle of cash flow determination for discounted cash flow analysis. Further, this approach precludes the use of net present value profiles which are pivotal when evaluating conflicts among mutually exclusive projects. In addition, use of certainty coefficient equivalents amounts to an acknowledgement that the concept, function and use of the cost of capital is improperly understood.

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