Laura Drake wishes to estimate the value of an asset expected to provide cash in

Question

Laura Drake wishes to estimate the value of an asset expected to provide cash inflows of $4,400 per year at the end of years 1 through 4 and $20,307 at the end of year 5. Her research indicates that she must earn 9% on low risk assets, 16% on average risk assets, and 21% 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

Lara Drake   Asset Valuation Present Value under Low Risk Category Details   Year 1 Year 2 Year 3 Year 4 Year 5 Cash flows               4,400                4,400                4,400              4,400          20,307 PV factor @9%               0.917                0.842                0.772              0.708            0.650 PV of The cash flows         4,036.70          3,703.39          3,397.61        3,117.07    13,198.16 Sum of PV of Cash flows= $ 27,452.92 Present Value under Avg. Risk Category Details   Year 1 Year 2 Year 3 Year 4 Year 5 Cash flows               4,400                4,400                4,400              4,400          20,307 PV factor @16%               0.862                0.743                0.641              0.552            0.476 PV of The cash flows         3,793.10          3,269.92          2,818.89        2,430.08      9,668.43 Sum of PV of Cash flows= $ 21,980.42 Present Value under High. Risk Category Details   Year 1 Year 2 Year 3 Year 4 Year 5 Cash flows               4,400                4,400                4,400              4,400          20,307 PV factor @21%               0.826                0.683                0.564              0.467            0.386 PV of The cash flows         3,636.36          3,005.26          2,483.69        2,052.63      7,829.23 Sum of PV of Cash flows= $ 19,007.17 A. Maximum Amts Lara should pay under Low Risk Avg Risk High Risk. the various risk categories; $ 27,452.92 $   21,980.42 $   19,007.17 B. If asset risk cannot be ascertained, Lara can pay at most $19,007.17 to be safe. C With Increasing risk the present value of the benfits from the asset gets lowe as the risk premium becomes higher.

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