Question

1.

a) The cash flows, CF of a firm are distributed as follows:

State	CF	State Probability
1	0.65	0.2
2	0.75	0.4
3	1.65	0.4
4	2.25	0.2

i. A cash inflow is expected to be realised, following the distribution above, at the end of each year, for ten consecutive years. Calculate the expected cash flow and its standard deviation.

ii. The expected return of the stock market is 20% per annum with an annual standard deviation of 1.5 while the correlation of cash flows of the firm and market returns is 0.3. Calculate the beta of the firm.

iii. Calculate the risk-adjusted discount rate if the risk-free rate is 4% per annum.

iv. Evaluate the present value of the cash flows.

b. Discuss the value and difficulty associated with estimating the fundamental value of risky investments. Explain the importance of valuing the flexibility that a firm has to strategically change its operations after a project has commenced operations. Compare the value of this flexibility with the value of the cash flows.

Answer 1

1)a)

i)

CF	Probability	CF * Probability
0.65	0.2	0.13	0.0845
0.75	0.4	0.3	0.225
1.65	0.4	0.66	1.089
2.25	0.2	0.45	1.0125
		1.54	2.411

1.54 is the Expected cash flow.

SD = = 0.19849

ii)

Market returns = 20% = 0.2

Stock returns = 0.3 * 0.2 = 0.06

Risk free rate = 4% = 0.04

Market rate - risk free rate = 0.16

Stock rate - risk free rate = 0.02

Beta = 0.16/0.02 = 8

iv)

PV =

= 4.71

b) There is a difficulty in estimating the fundamental value off risky investments because:

1. All definitions and measures associated with it are not straightforward
2. The usual analytical frameworks show limits
3. The behavior of investors and issuers is new