Ti i y

This model states that the value of the firm is equal to the discounted present worth of future profits. Under conditions of certainty, the numerator is profit, and the denominator is a time-value adjustment using the risk-free rate of return i. After time-value adjustment, the profits to be earned from various projects are strictly and completely comparable.

Under conditions of uncertainty, the profits shown in the numerator of the valuation model as n equal the expected value of profits during each future period. This expected value is the best available estimate of the amount to be earned during any given period. However, because profits cannot be predicted with absolute precision, some variability is to be anticipated. If the firm must choose between two alternative methods of operation, one with high expected profits and high risk and another with smaller expected profits and lower risks, some technique must be available for making the alternative investments comparable. An appropriate ranking and selection of projects is possible only if each respective investment project can be adjusted for considerations of both time value of money and risk. At least two popular methods are employed to make such adjustments. In the first, expected profits are adjusted to account for risk. In the second, the interest rate used in the denominator of the valuation model is increased to reflect risk considerations. Either method can be used to ensure that value-maximizing decisions are made.

certainty equivalent

Assured sum that equals an expected risky amount in utility terms

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