Question

A project has a forecasted cash flow of $115 in year 1 and $126 in year 2. The interest rate is 6%, the estimated risk premium on the market is 11.25%, and the project has a beta of .55. If you use a constant risk-adjusted discount rate, what is:

a. The PV of the project? (Do not round intermediate calculations. Round your answer to 2 decimal places.)

Present value            $

b. The certainty-equivalent cash flow in year 1 and year 2? (Do not round intermediate calculations. Round your answers to 2 decimal places.)

	Cash Flow
Year 1	$
Year 2	$

c. 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.)

	Ratio
Year 1
Year 2

Answer 1

Solution:
a.	Present value    $202.62
Working Notes:
	Computation of constant risk-adjusted discount rate based on CAPM
	r= rf + (rm-rf) x B
	rf= risk free rate = 6%
	(rm-rf)=market risk premium =11.25%
	Beta = 0.55
	r= rf + (rm-rf) x B
	r= 6% + 11.25% x 0.55
	r=6% + 6.1875%
	r=12.1875%
	The PV of the project = Cash flow 1/(1+r)^1 + Cash flow 2/(1+r)^2
	The PV of the project = 115/(1+0.121875)^1 + 126/(1+0.121875)^2
	The PV of the project = $202.6179189
	The PV of the project = $202.62
b.
	Cash Flow
Year 1	$108.66
Year 2	$112.48
Working Notes:
	Certainty-equivalent cash flow/(1+rf)^n = Cash flow n/(1+r)^n
Year 1	CEQ1 /(1+0.06)^1 = 115/(1+0.121875)^1
	CEQ1 = (115/(1+0.121875)^1) x (1+0.06)^1
	CEQ1 = 108.6573816
	CEQ1 =$108.66
Year 2	CEQ 2/(1+0.06)^2 = 126/(1+0.121875)^2
	CEQ2 = (126/(1+0.121875)^2) x (1+0.06)^2
	CEQ2 = 112.4846691
	CEQ2 =$112.48
b.
	Ratio
Year 1	0.94
Year 2	0.89
Working Notes:
Year 1	Ratio 1 = CEQ 1/Cash flow 1
	Ratio 1 = 108.6573816 /115
	Ratio 1 = 0.944846797
	Ratio 1 = 0.94
Year 2	Ratio 2 = CEQ 2/Cash flow 2
	Ratio 2 = 112.4846691/126
	Ratio 2 = 0.892735469
	Ratio 2 = 0.89
Please feel free to ask if anything about above solution in comment section of the question.