Question

A project has a forecasted cash flow of $126 in year 1 and $137 in year 2. The interest rate is 5%, the estimated risk premium on the market is 11.5%, and the project has a beta of 0.66. If you use a constant risk-adjusted discount rate, answer the following:

a. What is the PV of the project? (Do not round intermediate calculations. Round your answer to 2 decimal places.)

b. What is the certainty-equivalent cash flow in year 1 and year 2? (Do not round intermediate calculations. Round your answers to 2 decimal places.)

c. What is the ratio of the certainty-equivalent cash flows to the expected cash flows in years 1 and 2? (Do not round intermediate calculations. Round your answers to 2 decimal places.)

Answer 1

Risk adjusted discount rate =Interest rate + Risk premium * Beta

=5% +11.5% *0.66 =12.59%

a. Pv= sum of all {Inflow/(1+discount rate)^n}

Where n= number of years

Discount rate= risk adjusted rate = 12.59%

Hence, PV =126/ 1.1259 + 137/(1.1259)^2 = $ 219.98

b. Certainty equivalent cash flow=Expected cash flow/(1+ risk premium)

Risk premium= Risk adjusted rate – risk free rate = 12.59% -5% =7.59%

Hence for year 1, certainty equivalent cash flow = 126/1.0759 = $ 117.11

Hence for year 2, certainty equivalent cash flow = 137/1.0759 = $ 127.34

C. Ratio of certainty equivalent cash flow to expected cash floe =Certainty equivalent cash flow/expected cash flow.

For year 1= 117.11/126 =0.93

For year 2 = 127.34/137=0.93