I am buying a firm with an expected perpetual cash flow of $770 but am unsure of

Question

I am buying a firm with an expected perpetual cash flow of $770 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 7% and the expected rate of return on the market is 14%. (Input the amount as a positive value.)

I am buying a firm with an expected perpetual cash flow of $770 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 7% and the expected rate of return on the market is 14%. (Input the amount as a positive value.)

Explanation / Answer

Equity Risk Premium = Market Return - Risk Free Rate
= 14 - 7 = 7%

Risk Free Rate = 7%

Beta = 1

Expected Return on stock = Risk-free rate + Equity risk premium * Beta for stock
= 7 + 1*7 = 14%

Expected Price for Perpetual Scheme = Revenue per year / Discount Rate
= 770/.14
= $5500

We estimated beta to be 0.
Predicted Return = Expected Return on stock = Risk-free rate + Equity risk premium * Beta for stock
= 7 + 0*7
= 7%

Expected Price for Perpetual Scheme = Revenue per year / Discount Rate
= 770/.07
= $11000

Present Value Difference = Expected Price - Estimated Price
= 5500 - 11000
=-$5500

WE HAVE OVERPAID $5500.

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