Question

Asset valuation and risk  Personal Finance Problem   Laura Drake wishes to estimate the value of an asset expected to provide cash inflows of $ 3,600 for each of the next 4 years and ​$21, 029 in 5 years. Her research indicates that she must earn 5​% on​ low-risk assets, 9​% on​ average-risk assets, and 13​% on​ high-risk assets.

a.  Determine what is the most Laura should pay for the asset if it is classified as​ (1) low-risk,​ (2) average-risk, and​ (3) high-risk.

b.  Suppose Laura is unable to assess the risk of the asset and wants to be certain​ she's making a good deal. On the basis of your findings in part a​, what is the most she should​ pay? Why?

c. All else being the​ same, what effect does increasing risk have on the value of an​ asset? Explain in light of your findings in part a.

Answer 1

Cash Flow
a)	Year	1	2	3	4	5
	CF	3600	3600	3600	3600	21029
	The maximum amount to be paid is the NPV of these cash flows
	1)	NPV @ 5%	$29,242.19
	2)	NPV @ 9%	$25,330.40
	3)	NPV @ 13%	$22,121.80
b)	The most that she should pay is the conservative option of						$22,121.80
	This is because, it would mean that she is being conservative and not overpaying for a riskier asset
c)	With increasing risk, the price of the asset decreases due to increased discounting rate