Question

i am buying a firm with an expected perpetual cash flow of $490 but am unsure of its risk. If I think the beta of the firm is zero, when the beta is really 1, how much more will I offer for the firm than it is truly worth? Assume the risk-free rate is 7% and the expected rate of return on the market is 14%. (Input the amount as a positive value.)

Present value difference            $

Answer 1

​​​​​​Solution:-

Assume Beta is Zero, Then Present value will be discounted at risk free Rate @ 7%.

Present Value =

Present Value = $7,000.

If Beta is really 1, then Discounted Rate will be-

As per Capital Assets Pricing Model-

Discounted Rate = Risk free Rate + Beta * ( Market Return - Risk Free Return)

Discounted Rate = 0.07 + 1 * (0.14 - 0.07)

Discounted Rate = 14%

PV =

PV = $3,500

PV Difference = $7,000 - $3,500

PV Difference = $3,500.

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