Question

Consider a risky portfolio. The end-of-year cash flow derived from the portfolio will be either $50,000 or $150,000, with equal probabilities of .5. The alternative riskless investment in T-bills pays 5%.

a. If you require a risk premium of 10%, how much will you be willing to pay for the portfolio? (Round your answer to the nearest dollar amount.)

Value of the portfolio $________________ (Note answer is not $100,000)

I did this but it is not correct 50000*0.5+150000*0.5

Answer 1

R = Rate of discounting = Risk free rate + Risk Premium

R = 5% + 10% = 15%

Period = End of one year = 1

Now, find expected cash flow;

Expected cash flow =50000*0.5+150000*0.5

Future Value = Expected cash flow = 100000

Now let’s discount the future value or expected cash flow with rate of discounting;

Value of portfolio we will pay today = Future value / (1+R)^Period

Value of portfolio we will pay today = 100000 / (1+15%)^1

Value of portfolio we will pay today = $ 86,957