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

> Calculation of Required return

- Formula

As per CAPM

Re = Rf + (Rm - Rf ) Beta

where

Rf = Risk Free returns

(Rm-Rf) = Risk premium

- Calculation

Re = 5 + 11.50 * 0.66

     = 12.59 %

a) PV of the project

Year	Cashflow	PV Factor	PV
1	126	1/1.1259	111.91
2	137	1/1.12592	108.07
			219.98

b) Certainty equivalent Approach

> Concept - Certainty equivalent cash flow is the risk-free cash flow which an investor considers equivalent to a higher but risky expected cash flow.

> Formula - Expected Cash Flow / 1 + Risk Premium

> Calculation

- Year 1 = 126 / ( 1 + 0.1150 )

              = $ 113.01 Answer

- Year 2 = 137 / ( 1 + 0.1150 )

              = $ 122.87 Answer

c) Ratio of the Certainty equivalent Approach to expected cash flow

> Formula - Certainty equivalent Cash Flow / Expected Cash flow

> Calculation

- Year 1 = 113.01 / 126

              = 0.90 Answer

- Year 2 = 122.87 / 137

              = 0.90 Answer

Hope you understand the solution.