A project has an expected risky cash flow of $500 in year 3.The risk-free rate is 4%,the expected market rate of return is 14%,and the project's beta is 1.20.Calculate the certainty equivalent cash flow for year 3,CEQ₃.

Question

Quizplus · Accepted Answer

The certainty equivalent cash flow is calculated using the formula: CEQ = Expected Cash Flow / (1 + Risk Premium). The risk premium is calculated as Beta * (Market Rate - Risk-Free Rate). Here, Risk Premium = 1.20 * (14% - 4%) = 12%. Therefore, CEQ = $500 / (1 + 0.12) = $500 / 1.12 = $446.43. However, this is incorrect as the correct calculation should consider the risk-free rate for discounting the certainty equivalent cash flow: CEQ = $500 / (1 + 0.04)^3 = $500 / 1.124864 = $360.33.

A Project Has an Expected Risky Cash Flow of $500