Question

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?       

Answer 1

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 :-