Question

You are considering the purchase of real estate that will provide perpetual income that should average $65,000 per year. How much will you pay for the property if you believe its market risk is the same as the market portfolio’s? The T-bill rate is 5%, and the expected market return is 8.0%.

Answer 1

$812,500

Step-by-step explanation:

If market risk is the same as market portfolio, then the beta is equal to 1.

Use the CAPM formula to find the appropriate discount rate for valuation of this real estate;

CAPM; r = rf + beta(rM - rf ) whereby,

rf = risk free rate = 5% or 0.05 as a decimal

rM = Market return = 8% or 0.08

CAPM ; r = 0.05 + 1(0.08 - 0.05)

r = 0.05 + 0.03

r = 0.08 or 8%

Present value of perpetual CF formula;

PV = CF/ rate

PV = 65,000 / 0.08

PV = 812,500

Therefore, you should pay $812,500