Asset valuation and risk Personal Finance Problem Laura Drake wishes to estimate

Question

Asset valuation and risk Personal Finance Problem Laura Drake wishes to estimate the value of an ass et expected to provide cash inflows of $4,400 per year at the end of years 1 through 4 and $22,375 at the end of year 5 Her research indicates that she must earn 9% on low-risk assets 17% on average-risk assets, and 19% 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 assel? Explain in light of your findings in part a. a. (1) The most Laura should pay for the asse if it is classified as low-risk is Round to the nearest cent.) 2) The most Laura should pay for the asselt ifit is classified as average-risk is (Round to the nearest cent) (3) The most Laura should pay for the asset if it is classified as high-risk is SRound to the nearest cent.) 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, the most she should pay is (Round to the nearest cent.) 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. (Select the best answer below.) O A. By increasing the risk of cash flows received from an asset, the required rate of return increases, which increases the value of the asset. O B. By increasing the risk of cash flows received from an asset, the required rate of return increases, which reduces the value of the asset ° C. By increasing the risk of cash flows received from an asset, the required rate of return decreases, which reduces the value of the asset.

Explanation / Answer

a: The maximum amount to be paid= Annuity*(1-1/(1+r)^n)/r + FV/(1+r)^n

1:low risk asset= 4400*(1-1/1.09^4)/0.09+ 22375/1.09^5= 28796.98

2: Average risk = 4400*(1-1/1.17^4)/0.17+ 22375/1.17^5 = 22275.72

3: High risk = 4400*(1-1/1.19^4)/0.19+ 22375/1.19^5= 20986.00

B: The most she should pay = $28796.98 (Since that will cover all the scenarios. Amount higher than this will not even cover least risk.)

C: Option B

Higher risk increases the discount rate which decreases the Present value since PV=FV/(1+r)^n. Higher the value of r lower will be the PV.

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