Question

# An investor has the choice to accept a guaranteed K9 million cash inflow or an option...

An investor has the choice to accept a guaranteed K9 million cash inflow or an option with the following expectations:

• A 30% chance of receiving K7.5 million
• A 45% chance of receiving K15.5 million
• A 25% chance of receiving K4 million

Assume the risk-adjusted rate of return used to discount this option is 13.75% and the risk-free rate is 3.25%.

1. Calculate the expected cash flow of this investment.
2. Calculate the certainty equivalent cash flow.
3. If the investor prefers to avoid risk, what guaranteed option should accept?

Given,

Cash flow 1 (CF1) = K7.5 million

Cash flow 2 (CF2) = K15.5 million

Cash flow 3 (CF3) = K4 million

Probability 1 (P1) = 30% or 0.30

Probability 2 (P2) = 45% or 0.45

Probability 3 (P3) = 25% or 0.25

Risk adjusted rate of return = 13.75%

Risk free rate = 3.25%

Solution :-

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