A project has an expected risky cash flow of $500 in year 2. The risk-free rate is 4 percent, the expected market rate of return is 14 percent, and the project's beta is 1.20. Calculate the certainty equivalent cash flow for year 2, CEQ₂.

Question

Quizplus · Accepted Answer

The certainty equivalent cash flow (CEQ) can be calculated using the formula: CEQ = Expected Cash Flow / (1 + Risk Premium), where the Risk Premium = Beta * (Market Rate of Return - Risk-Free Rate). Here, the Risk Premium = 1.20 * (14% - 4%) = 12%. Thus, the CEQ for the $500 expected cash flow is $500 / (1 + 12%) = $500 / 1.12 = $446.43. However, none of the options match this calculation directly, suggesting a potential misunderstanding in the question's setup or a mistake in the calculation. Given the options, the closest approach to the correct methodology was intended, but it appears there's a discrepancy in the final values provided. Re-evaluating with the correct approach: The correct formula for adjusting for risk in this context should actually involve the CAPM to find the appropriate discount rate, then discount the cash flow at that rate. However, the provided answer choices and the calculation method initially described don't align with standard financial calculations for certainty equivalents or the use of CAPM directly for this purpose.

A Project Has an Expected Risky Cash Flow of $500