Question

Assume that the risk-free rate is 5%, the risk-adjusted discount rate is 10%, the expected cash flow for t = 1 is 495, and the expected cash flow for t = 2 is 508.2

a)Assume that the cash flow risk increases geometrically through time. Compute the present value of the cash flow stream using the certainty equivalent method.

b) Assume that the cash flow risk remains constant through time. Compute the present value of the cash flow stream using the risk-adjusted discount rate method.

Answer 1

a) To calculate the present value of the cash flow where Cash flow is growing

and using the certainty equivalent method, it means in risk adjusted cash flow risk free rate to be deducted or we can say when it is a thinking that cash flow is higher but riskier then certainty equivalent method is adopted

To calculate PV of the cash Flow formula is =CF(t1)/((risk adjusted discount rate-risk free rate)-growth rate)

To calculate Growth rate =(t2 cash flow-t1 cash flow)/t1 cash flow

=(508.2-495)/495

2.67%

PV of the Cash flow=495/((10%-5%)-2.67%)

$ 21,244.64

b) to calculate the PV of the constant cash flow to perpetuity formula is

=CF(T1)/risk adjusted discount rate

=495/10%

$    4,950.00