What is the expected cash flow need of investor at year 1? Suppose an investor h

Question

What is the expected cash flow need of investor at year 1?
Suppose an investor has $100 with him today. There is a 5% chance that he will fall sick after 1 year and then need this cash to pay for his healthcare expenses. He has two investment choices: A and B. A is a liquid investment that gives 2% annual return. If the investment continues from year 1 to 2, the investor keeps getting this 2% return. B is illiquid, and it must remain invested for two years. If investment B is liquidated at year 1, it loses 20% of principal amount, but if it stays in the investment, then it gives a one-time 20% return (i.e. gives $120) after two years.

Please answer the following questions based on this information. Only numbers, rounded to two decimal places when applicable, are necessary. What is the expected cash flow need of investor at year 1?

Explanation / Answer

The expected cash flow need for the investors is $100 in case he falls sick (5%) or $0 if nothing happens (95%)

Expected cash flow need = 5% * $100 + 95% *0

Expected cash flow need of the investor at year 1 = $5

Note: Since the questions talk about what is the "NEED" we have only calculated his need of cash flow if sick.We have not considered other numbers for this question since they are expected returns and not expected need

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