Laura Drake wishes to estimate the value of an asset expected to provide cash in
ID: 2739411 • Letter: L
Question
Laura Drake wishes to estimate the value of an asset expected to provide cash inflows of $2,300 per year at the end of years 1 through 4 and $10,241 at the end of year 5. Her research indicates that she must earn 9% on low-risk assets, 16% 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 asset? Explain in light of your findings in part a.
Explanation / Answer
Value of an asset is the PV of its expected cash inflows discounted at the rate applicable for the risk attached to the cash flows. The PV of the cash flows at different discount rates (risk) are worked out below:
YEARS CASH INFLOWS PVIF-9% PVIF-16% PVIF-19% PV @ 9% PV @ 16% PV @ 19% 1 2300 0.9174 0.8621 0.8403 2110 1983 1933 2 2300 0.8417 0.7432 0.7062 1936 1709 1624 3 2300 0.7722 0.6407 0.5934 1776 1474 1365 4 2300 0.7084 0.5523 0.4987 1629 1270 1147 5 10241 0.6499 0.4761 0.4190 6656 4876 4291 14107 11312 10360 a) The most Laura should pay for the asset is the PV of cash flows disconted at the risk adjusted rate of return. Hence, the amount to be paid is for low risk for avg rsik for high risk $14,107 $11,312 $10,360 b) If Laura is unable to assess the risk, then she should pay the least of the amounts in (a) that is $10360. It will lessen his risk. c) Increase in risk raises the required rate of return, which in turn lowers the value of the asset, other things remaining the same.Related Questions
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