Laura Drake wishes to estimate the value of an asset expected to provide cash in
ID: 2736924 • Letter: L
Question
Laura Drake wishes to estimate the value of an asset expected to provide cash inflows of $3,800 per year at the end of years 1 through 4 and $21,096 at the end of year 5. Her research indicates that she must earn 12% on low risk assets, 17% on average risk assets, and 21% on high risk assets.
A. determine what is the most Laura should pay for she asset if it is classified(1) low risk, (2) average risk, and (3) high risk (Round to the nearest cent.)
B. Suppose Laura is unable to assess the risk of the asset and wants to be certain she is making a good deal. On the basis of your findings in part A, what is the most she should pay? Why? (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.)
A.By increasing the risk of cash flows received from an asset, the required rate of returnincreases, which reduces the value of the asset.
B.By increasing the risk of cash flows received from an asset, the required rate of returnincreases, which increases the value of the asset.
C.By increasing the risk of cash flows received from an asset, the required rate of returndecreases, which reduces the value of the asset.
Explanation / Answer
A)
B)If she has to be certain that she is making a good deal than she should pay maximum $17,787.10 because that is the lowest value that the asset can have and the asset value can only increase above this value therefore she is certain to make a good deal.
C)Increasing the risk decreases the value of the asset as is evident form the answer in A)
Thus select A.By increasing the risk of cash flows received from an asset, the required rate of return increases, which reduces the value of the asset.
cash inflows low risk average risk high risk Year(t) CF PV=CF/1.12^t PV=CF/1.17^t PV=CF/1.21^t 1 3,800 3392.857143 3247.863248 3140.495868 2 3,800 3029.336735 2775.951494 2595.45113 3 3,800 2704.764942 2372.608114 2145.000934 4 3,800 2414.968698 2027.870183 1772.728045 5 21,096 11970.43695 9622.12087 8133.421234 Value(sum PVs) $ 23,512.36 $ 20,046.41 $ 17,787.10 Value is the most Laura should pay for asset.Related Questions
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