CEQ

In Entrepreneurial Finance the Certainty Equivalent Cash Flow or CEQ is defined as a common method of estimating Present Value. The second common method mentioned is the Risk Adjusted Discount Rate. In the CEQ method instead of adjusting the discount rate (which is done in the RADR) the risk adjustment is made directly to the cash flow. After that the risk-adjusted or, better in this case the certainty equivalent cash flow is converted to Present Value by discounting at the risk free rate. Thus, if:

$C_{jt}$ is the expected future cash flow of asset $j$ at time $t$ the certainty equivalent cash flow $CE(C_{jt})$ can be described as follows:

$CE(C_{jt})$ $=$ $C_{jt}-RD_{jt}$

Where: $RD_{jt}$ is the dollar valued discount to $C_{jt}$ that is required to convert the risky expected cash flow to its certainty equivalent.

Certainty Equivalent Cash Flow (CEQ) is:

$PV$ - $\sum {\frac {C_{t}-RD_{r}}{(1+r_{pt})^{t}}}$

Issues:

• What cash flows should be valued?
• How risky cash flows adjusted to their certainty equivalents?
• What is the discount rate for valuing certain future cash flows?