Question

Davis Company is formed with $5,000 in equity and is expected to generate the following cash flows (all occurring at the end of one year):

            Cash Flows                  Probability

            $63,000                               0.3

            39,000                              0.5

              28,000                               0.2

Determine if the equity is high enough to absorb expected losses assuming the appropriate discount rate is 6%. Show your work to receive credit.

Davis Company is formed with $5,000 in equity and is expected to generate the following cash flows (all occurring at the end of one year):

            Cash Flows                  Probability

            $63,000                               0.3

            39,000                              0.5

              28,000                               0.2

Determine if the equity is high enough to absorb expected losses assuming the appropriate discount rate is 6%. Show your work to receive credit.

Answer 1

Statement showing Expected cash flow at end of year 1

Sr	Cash flow	Probability	Cash flow x Probability
1	63000	0.3	18900
2	39000	0.5	19500
3	28000	0.2	5600
Expected Cash flow at end of year 1	44000

NPV =PV of cash flow at end of year 1 - Initial investment

PV of cash flow at end of year 1 = cash flow at end of year 1/(1+r)

r = 6%

Thus PV of cash flow at end of year 1 = 44000/(1+6%)

=44000/(1+0.6)

=44000/1.06

=41509.43 $

Thus NPV = 41509.43 -5000

= 36509.43$

Thus  the equity is high enough to absorb expected losses