Laura Drake wishes to estimate the value of an asset expected to provide cash in
ID: 2736373 • Letter: L
Question
Laura Drake wishes to estimate the value of an asset expected to provide cash inflows of $1,200 per year at the end of years 1 through 4 and $3,600 at the end of year 5. Her research indicates that she must earn 6% on low-risk assets, 12% on average-risk assets, and 18% 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.
Explanation / Answer
A./
1./ LOW RISK
LAURA SHOULD PAY THE PRESENT VALUE OF ALL FUTURE CASH PAYMENT
PRESENT VALUE
= $1200 * PVIFA 6%, 4 PERIODS + $3600 * PVIF 6%,5PERIODS
= $1200 * 3.4651 + $3600 * 0.7473
= $4158.12 + $2690.28
= $6848.4
2./ AVERAGE RISK
LAURA SHOULD PAY THE PRESENT VALUE OF ALL FUTURE CASH PAYMENT
PRESENT VALUE
= $1200 * PVIFA 12%, 4 PERIODS + $3600 * PVIF 12%,5PERIODS
= $1200 * 3.0373 + $3600 * 0.5674
= $3644.76 + $2042.64
= $5687.40
3./ HIGH RISK
LAURA SHOULD PAY THE PRESENT VALUE OF ALL FUTURE CASH PAYMENT
PRESENT VALUE
= $1200 * PVIFA 18%, 4 PERIODS + $3600 * PVIF 18%,5PERIODS
= $1200 * 2.6901 + $3600 * 0.4371
= $3228.12 + $1573.56
= $4801.68
B./
SHE SHOULD PAY $4801.68 IF SHE IS UNSURE OF THE RISK BECAUSE THAT IS THE WORST CASE SCENARIO.
C./
ALL ELSE BEING SAME THE INCEREASEING RISK WILL REDUCE THE VALUE OF AN ASSET, AS WE CAN CLEARLY DETERMINED IN PART A THAT AT LOW RISK THE VALUE OF ASSET IS MORE BUT THE VALUE OF ASSET IS GOING ON DECEREASEING WHEN THE RISK IS INCEREASEING.
SO WE CAN ALTERNATIVELY SAY THAT THERE IS A INVERSE RELASONSHIP BETWEEN THE RISK OF AN ASSET AND THE VALUE OF AN ASSET.
Related Questions
Navigate
Integrity-first tutoring: explanations and feedback only — we do not complete graded work. Learn more.