What is 'Certainty Equivalent'

The certainty equivalent is a guaranteed return that someone would accept rather than taking a chance on a higher, but uncertain, return. To put it another way, the certainty equivalent is the guaranteed amount of cash that would yield the same exact expected utility as a given risky asset with absolute certainty, and represents the opportunity cost of risk.

BREAKING DOWN 'Certainty Equivalent'

Investments must pay a risk premium to compensate investors for the possibility that they may not get their money back. If an investor has a choice between a U.S. government bond paying 3% interest and a corporate bond paying 8% interest, and he chooses the government bond, the payoff is the certainty equivalent. The company would need to offer this particular investor a potential return of more than 8% on its bonds to convince him to buy. A company seeking investors can use the certainty equivalent as a basis for determining how much more it needs to pay to convince investors to consider the riskier option. The certainty equivalent varies because each investor has a unique risk tolerance.

Certainty Equivalent and Cash Flow

The idea of certainty equivalent can also be applied to cash flow. The certainty equivalent cash flow is the risk-free cash flow that an investor or manager considers equal to a different expected cash flow which is higher, but also riskier. The formula for calculating the certainty equivalent cash flow is as follows:

Certainty equivalent cash flow = expected cash flow / (1 + risk premium)

The risk premium is calculated as the risk-adjusted rate of return minus the risk-free rate. The expected cash flow is calculated by taking the probability-weighted dollar value of each expected cash flow and adding them up.

For example, imagine that an investor has the choice to accept a guaranteed $10 million cash inflow or an option with the following expectations:

1. A 30% chance of receiving $7.5 million

2. A 50% chance of receiving $15.5 million

3. A 20% chance of receiving $4 million

Based on these probabilities, the expected cash flow of this scenario is:

Expected cash flow = (30% x $7.5 million) + (50% x $15.5 million) + (20% x $4 million) = $10.8 million

Assume the risk-adjusted rate of return used to discount this option is 12% and the risk-free rate is 3%. Thus, the risk premium is (12% - 3%), or 9%. Using the above equation, the certainty equivalent cash flow is:

Certainty equivalent cash flow = $10.8 million / (1 + 9%) = $9.908 million.

Based on this, if the investor prefers to avoid risk, he should accept any guaranteed option worth more than $9.908 million.

RELATED TERMS
  1. Cash Flow Statement

    A cash flow statement is a financial statement that provides ...
  2. Non-Operating Cash Flows

    Non-operating cash flows are inflows and outflows of cash that ...
  3. Sales To Cash Flow Ratio

    The sales to cash flow ratio shows how efficiently a business ...
  4. Unconventional Cash Flow

    An unconventional cash flow is a series of inward and outward ...
  5. Incremental Cash Flow

    Incremental cash flow is the gain received from a new project. ...
  6. Rate of Return

    A rate of return is the gain or loss on an investment over a ...
Related Articles
  1. Investing

    Evaluating A Statement Of Cash Flows

    The metrics for the Statement of Cash Flows is best viewed over time.
  2. Tech

    Cash Flow Is King: How to Keep it Running

    Why is cash flow so important, and what steps can a business take to improve it?
  3. Investing

    What Is Cash Flow From Investing Activities?

    Cash flow from investing is listed on a company's cash flow statement and includes any inflows or outflows of cash from a company's long-term investments. 
  4. Small Business

    Understanding Cash Flow

    Learn about the different types of cash flows and the importance for businesses to properly manage their cash flows.
  5. Investing

    What Is a Cash Flow Statement?

    The Cash Flow Statement measures whether a company generates enough cash to meet its operating expenses.
  6. Investing

    Cash flow statement: Analyzing cash flow from financing activities

    The financing activity in the cash flow statement measures the flow of cash between a firm and its owners and creditors.
  7. Investing

    Cash Flow From Operating Activities

    Cash flow from operating activities is a section of the Statement of Cash Flows that is included in a company’s financial statements after the balance sheet and income statements.
  8. Investing

    10 Ways to Loosen Up Your Cash Flow

    Cash flow is king. Here are a few ways to fatten it up.
  9. Investing

    Cash flow statement: Analyzing cash flow from investing activities

    Here, you'll find an overview of cash flow from investing activities — one of three primary categories in the statement of cash flows.
RELATED FAQS
  1. How should I evaluate a company with negative cash flow investing activities?

    Negative cash flow from investing activities should be evaluated since it could be a warning sign. However, it can also mean ... Read Answer >>
  2. Where Do Companies Keep Their Cash?

    Cash and cash equivalents are the first items on a company's balance sheet, but they are not same. Read Answer >>
  3. How are cash flow and free cash flow different?

    Both cash flow and free cash flow are financial metrics that measure a company's liquidity, but one shows how effectively ... Read Answer >>
  4. What is the difference between cash flow and fund flow?

    See how cash flow and fund flow differ from each other, and why fund flow can be used very differently by accountants and ... Read Answer >>
  5. How do net income and operating cash flow differ?

    Net income is the profit a company has earned for a period while cash flow from operating activities measures, in part, the ... Read Answer >>
Trading Center