Question

With uncertain future cash receipts, the manager decides to adjust them with the appropriate certainty equivalent factor. The company has a cost of capital of 10%. The risk-free rate is 8%. Find the certainty cash flow for year 1 of this option: 30% of $7.5 million, 50% of $15.5 million and 20% of $4 million.

____

1. $10.603 million
2. $9.908 million
3. $11.08 million
4. $9.64 million

Hint: α_t = PVIF(RADR, t)/PVIF(R_F, t)

Answer 1

Certainity Equivalent Factor = PVIF(10%,1) / PVIF(8%,1)

= 0.90909091 / 0.92592593

= 0.981818178

Expected Cash Flows = [$7.5 million * 30%] + [$15.5 million * 50%] + [$4 million * 20%]

= $2.25 million + $7.75 million + 0.8 million

= $10.8 million

Certain Cash Flows = Expected Cash Flows * Certainity Equivalent Factor

= $10.8 million * 0.981818178

= $10.6036363 million

Therefore, Certain cash flow for year 1 for this option is $10.603 million

Option A is correct