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QUESTION THREE Hezborn has the choice to accept a guaranteed $10 million cash flow or an...

QUESTION THREE

Hezborn has the choice to accept a guaranteed $10 million cash flow or an option with the following;

  1. A 30% chance of receiving $7.5 million
  2. A 50% chance of receiving $15.5 million
  3. A 20% chance of receiving $4 million

  1. Calculate expected cash flow.                          [6 marks]

Assume the risk-adjusted rate of return used to discount this option in 12% and the risk-free rate is 3%. This, the risk premium is (12% - 3%) or 9%

(show the workings)

  1. Using above equation, compute the certainty equivalent cash flow. Advise the investor decision to make if he wants to avoid risk.                                   [9 marks]
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