Question

Asset valuation and risk  Personal Finance Problem   Laura Drake wishes to estimate the value of an asset expected to provide cash inflows of $1,800 for each of the next 4 years and ​$8,710 in 5 years. Her research indicates that she must earn 4​% on​ low-risk assets, 8​% on​ average-risk assets, and 14​% 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.

Answer 1

Step1:
Cash flow from year 1 to 4= $1400

Cash flow for year 5= $8710

The most say willing to pay= present value of all future cash flows.

Discounted at-risk level%

Step 2:
a. Low risk level (Return 4%)
Present value of all future cash flows= [1800/(1.04)^1]+ [1800/(1.04)^2]+ [1800/(1.04)^3]+ [1800/(1.04)^4]+ [8710/(1.04)^5]
= $13,692.80

The most she is willing to pay = $13,692.80

Average risk level (Return 8%)
Present value of all future cash flows= [1800/(1.08)^1]+ [1800/(1.08)^2]+ [1800/(1.08)^3]+ [1800/(1.08)^4]+ [8710/(1.08)^5]
= $11,889.71

The most she is willing to pay = $11,889.71

High risk level (Return 12%)
Present value of all future cash flows= [1800/(1.12)^1]+ [1800/(1.12)^2]+ [1800/(1.12)^3]+ [1800/(1.12)^4]+ [8710/(1.12)^5]
= $10,409.52

The most she is willing to pay=$10,409.52

Step 3:
b. She needs to be conservative and assume a high risk. She must be willing to pay $10,409.52 for the asset to make a good deal.

c.
As the risk increases the money Laura is willing to pay decreases.

Therefore,
As the risk increases the value of asset decreases.