Question

I am buying a firm with an expected perpetual cash flow of $630 but am unsure of its risk. If I think the beta of the firm is zero, when the beta is really 1, how much more will I offer for the firm than it is truly worth? Assume the risk-free rate is 6% and the expected rate of return on the market is 18%. (Input the amount as a positive value.)

Present value difference            $ ____

Answer 1

When Beta is 0, expected rate of return is risk free rate of return.
Present value with 0 beta			=	Annual cash flows / Expected rate of return
			=	$             630	/	6%
			=	$       10,500
When firm has beta of 1, expected return of firm is as equal to market return.
Present value with beta of 1			=	Annual cash flows / Expected rate of return
			=	$             630	/	18%
			=	$         3,500
Present value difference			=	$       10,500	-	$    3,500
			=	$         7,000