Certainty Equivalent Method
MacKenzie-Rabb, Inc., is a Texas-based manufacturer and distributor of components and replacement parts for the auto, machinery, farm, and construc- tion equipment industries. The company is currently funding a program of capital investment that is necessary to reduce production costs and thereby meet an onslaught of competition from low-cost suppliers located in Mexico and throughout Latin America. MacKenzie-Rabb has a limited amount of capital available and must carefully weigh both the risks and potential rewards associated with alternative investments. In particular, the company seeks to weigh the advantages and disadvantages of a new investment project, project X, in light of two other recently adopted investment projects, project Y and project Z:
Expected Cash Flows After Tax (CFAT) per Year
|
Year
|
Project X
|
Project Y
|
Project Z
|
|
2001
|
$10,000
|
$20,000
|
$0
|
|
2002
|
10,000
|
18,000
|
2,500
|
|
2003
|
10,000
|
16,000
|
5,000
|
|
2004
|
10,000
|
14,000
|
7,500
|
|
2005
|
10,000
|
12,000
|
10,000
|
|
2006
|
10,000
|
10,000
|
12,500
|
|
2007
|
10,000
|
8,000
|
15,000
|
|
2008
|
10,000
|
6,000
|
17,500
|
|
2009
|
10,000
|
4,000
|
20,000
|
|
2010
|
10,000
|
2,000
|
22,500
|
|
PV of Cash Flow @ 5%
|
|
$91,131
|
$79,130
|
|
Investment Outlay in 2000:
|
$60,000
|
$60,000
|
$50,000
|
A. Using a 5% risk-free rate, calculate the present value of expected cash flows after tax (CFAT) for the 10-year life of project X.
B. Calculate the minimum certainty equivalent adjustment factor for each project's CFAT that would justify investment in each project.
C. Assume that the management of MacKenzie-Rabb is risk averse and uses the certainty equivalent method in decision making. Is project X as attractive or more attractive than projects Y and Z?
D. If the company would not have been willing to invest more than $60,000 in project Y nor more than $50,000 in project Z, should project X be undertaken?