Laura Drake wishes to estimate the value of an asset expected to provide cash in
ID: 2721754 • Letter: L
Question
Laura Drake wishes to estimate the value of an asset expected to provide cash inflows of $3000 per year at the end of years 1 through 4 and $14288 at the end of year 5. Her research indicates that she must earn 11% on low risk assets, 14% on average risk assets, and 19% on high risk assets.
a. determine what is the most Laura should pay for he asset if it is classified(1) low risk, (2) average risk, and (3) high risk
b. Suppose Laura is unable to assess the risk of the asset and wants gto be sertain sheis 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.
Explanation / Answer
Part A)
The amount of money Laura should pay would be the PV of cash flows.
Year
Cash flow
PV factor 11%
PV
1
3000
0.9009
$2,702.70
2
3000
0.8116
$2,434.87
3
3000
0.7312
$2,193.57
4
3000
0.6587
$1,976.19
5
14288
0.5935
$8,479.23
Amount to pay
$17,786.57
Year
Cash flow
PV factor 14%
PV
1
3000
0.8772
$2,631.58
2
3000
0.7695
$2,308.40
3
3000
0.6750
$2,024.91
4
3000
0.5921
$1,776.24
5
14288
0.5194
$7,420.74
Amount to pay
$16,161.88
Year
Cash flow
PV factor 19%
PV
1
3000
0.8403
$2,521.01
2
3000
0.7062
$2,118.49
3
3000
0.5934
$1,780.25
4
3000
0.4987
$1,496.01
5
14288
0.4190
$5,987.38
Amount to pay
$13,903.13
Part b)
She should pay for average risk if she is unable to determine the amount of risk she is going to take. She should pay $16,161.88 for the investment.
Part c)
As risk increases, return required also increases. We know required return and value has inverse relationship. This is why as risk increases, value of asset decreases.
Year
Cash flow
PV factor 11%
PV
1
3000
0.9009
$2,702.70
2
3000
0.8116
$2,434.87
3
3000
0.7312
$2,193.57
4
3000
0.6587
$1,976.19
5
14288
0.5935
$8,479.23
Amount to pay
$17,786.57
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