A project has an expected risky cash flow of $200 in year 1. The risk-free rate is 6 percent, the expected market rate of return is 16 percent, and the project's beta is 1.50. Calculate the certainty equivalent cash flow for year 1, CEQ₁. A)$175.21 B)$165.29 C)$228.30 D)$182.76

Question

Quizplus · Accepted Answer

The formula for calculating the certainty equivalent cash flow is:

CEQ = RF + (EMRP x Beta x Risk Premium)

Where RF is the risk-free rate, EMRP is the expected market return premium (i.e., the difference between the expected market rate of return and the risk-free rate), and Beta is the project's beta. The Risk Premium is the difference between the expected risky cash flow and the risk-free cash flow.

Using the given values, we get:

RF = 6%
EMRP = 16% - 6% = 10%
Beta = 1.50
Risk Premium = $200 - ($200 / (1 + 6%)) = $188.68

So, CEQ = 6% + (10% x 1.50 x $188.68) = $175.21

Therefore, the best choice is A as it correctly calculates the certainty equivalent cash flow for year 1.

A Project Has an Expected Risky Cash Flow of $200