A project has an expected risky cash flow of 500 in year 4 T

A project has an expected risky cash flow of $500, in year 4. The risk-free rate is 4%, the market rate of return is 13%, and the project\'s beta is 1.2. Calculate the certainty equivalent cash flow for year 4. Show steps.

Solution

Risk adjusted discount rate =Rf +[Beta (Rm-Rf)]

                          = 4 +[1.2 (13 -4)]

                           = 4+ [1.2 *9]

                           = 4 + 10.8

                           = 14.8%

Risk premium = Risk adjusted discount rate - Risk free rate

          = 14.8-4

         = 10.8%

certainty equivalent cash flow for year 4 = Expected cash flow /(1+risk premium]

                = 500/(1+.108)

                = 500/1.108

                = $ 451.26