Question

Asset valuation and risk  Personal Finance Problem   Laura Drake wishes to estimate the value of an asset expected to provide cash inflows of $4,500for each of the next 4 years and $20,724

in 5 years. Her research indicates that she must earn 3​% on​ low-risk assets, 7​% on​ average-risk assets, and 13​% 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

Answer 1

	Year	Low risk	Average risk	High risk
	1	4500	4500	4500
	2	4500	4500	4500
	3	4500	4500	4500
	4	4500	4500	4500
	5	20724	20724	20724
a	Maximum amount to pay	$34,603.65	$30,018.38	$24,633.28
b	She should pay on the basis of average risk since that is the normal risk that the asset has.
c	Higher the risk, lower will be its present value.
	Hence, the value of the asset decreases as the risk increases
	This is because the discount factor is higher.

WORKINGS