A project has an expected risky cash flow of $500 in year 3. 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 3, CEQ₃.

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Quizplus · Accepted Answer

The certainty equivalent cash flow can be calculated using the formula: CEQ = Expected Cash Flow / (1 + Risk Premium)^n, where the Risk Premium = Expected Market Return - Risk-Free Rate, and n is the number of periods (in this case, 3 years). Given the project's beta is 1.20, the project's required return can be calculated using the CAPM formula: Required Return = Risk-Free Rate + Beta * (Market Return - Risk-Free Rate) = 4% + 1.20 * (14% - 4%) = 16%. The certainty equivalent cash flow is then calculated as $500 / (1 + 0.16)^3 = $360.33.

A Project Has an Expected Risky Cash Flow of $500