Question

aura Drake wishes to estimate the value of an asset expected to provide cash inflows of

$ 3 comma 500$3,500

for each of the next 4 years and

​$14 comma 77114,771

in 5 years. Her research indicates that she must earn

44​%

on​ low-risk assets,

88​%

on​ average-risk assets, and

1616​%

on​ high-risk assets.

a.  Determine what is the most Laura should pay for the asset if it is classified as​ (1) low-risk,​ (2) average-risk, and​ (3) high-risk.

b.  Suppose Laura is unable to assess the risk of the asset and wants to be certain​ she's making a good deal. On the basis of your findings in part

a​,

what is the most she should​ pay? Why?

c. All else being the​ same, what effect does increasing risk have on the value of an​ asset? Explain in light of your findings in part

a.

a. ​ (1) The most Laura should pay for the asset if it is classified as​ low-risk is

​$nothing.

​(Round to the nearest​ cent.)

​(2) The most Laura should pay for the asset if it is classified as​ average-risk is

​$nothing.

​ (Round to the nearest​ cent.)

​(3) The most Laura should pay for the asset if it is classified as​ high-risk is

​$nothing.

​(Round to the nearest​ cent.)

b.  Suppose Laura is unable to assess the risk of the asset and wants to be certain​ she's making a good deal. On the basis of your findings in part

a​,

the most she should pay is

​$nothing.

​(Round to the nearest​ cent.)

c. All else being the​ same, what effect does increasing risk have on the value of an​ asset? Explain in light of your findings in part

a.

​(Select the best answer​ below.)

A.

By increasing the risk of cash flows received from an​ asset, the required rate of return​increases, which increases the value of the asset.

B.

By increasing the risk of cash flows received from an​ asset, the required rate of return​increases, which reduces the value of the asset.

C.

By increasing the risk of cash flows received from an​ asset, the required rate of return​decreases, which reduces the value of the asset.

Answer 1

a)

Low Risk Assets
Interest rate	4%
Year	Year-End Cash Flow	Pv Factor	Amount
0	$                                 -	1	$                 -
1	$                    3,500.00	0.962	$    3,367.00
2	$                    3,500.00	0.925	$    3,237.50
3	$                    3,500.00	0.889	$    3,111.50
4	$                    3,500.00	0.855	$    2,992.50
5	$                  14,771.00	0.822	$ 12,141.76
			$ 24,850.26
Average Risk assets
Interest rate	8%
Year	Year-End Cash Flow	Pv Factor	Amount
0	$                                 -	1	$                 -
1	$                    3,500.00	0.926	$    3,241.00
2	$                    3,500.00	0.857	$    2,999.50
3	$                    3,500.00	0.794	$    2,779.00
4	$                    3,500.00	0.735	$    2,572.50
5	$                  14,771.00	0.681	$ 10,059.05
			$ 21,651.05
high-risk assets
Interest rate	16%
Year	Year-End Cash Flow	Pv Factor	Amount
0	$                                 -	1	$                 -
1	$                    3,500.00	0.862	$    3,017.00
2	$                    3,500.00	0.743	$    2,600.50
3	$                    3,500.00	0.641	$    2,243.50
4	$                    3,500.00	0.552	$    1,932.00
5	$                  14,771.00	0.476	$    7,031.00
			$ 16,824.00

b)

the basis of your findings in part a​, the most she should pay is 16,824.00

c)By increasing the risk of cash flows received from an asset, the required rate of return increases which reduces the value of the asset.