Question

Ben, a sole trader, is analysing a potential project and he expects a risky cash flow of $ 14801 at the end of year 3. Given the risk-free rate is 3 % and the project’s cost of capital is 14 %. Calculate the project’s certainty equivalent cash flow for year 3. (Round your answer to the nearest dollar) Certainty equivalent cash flow (in $) for year 3 =

Answer 1

To calculate the project's certainty equivalent cash flow for year 3, we need to consider the risk-free rate and the project's cost of capital. The certainty equivalent cash flow represents the guaranteed amount that would be considered equally desirable as the risky cash flow.

First, we need to determine the present value of the risky cash flow at the end of year 3. We can use the formula for present value:

PV = FV / (1 + r)^n

Where PV is the present value, FV is the future value, r is the discount rate, and n is the number of periods.

In this case, the risky cash flow at the end of year 3 is $14,801, the risk-free rate is 3%, and the project's cost of capital is 14%. Let's calculate the present value:

PV = 14801 / (1 + 0.14)^3

PV = 14801 / (1.14)^3

PV ≈ 14801 / 1.4887

PV ≈ 9932.60

The present value of the risky cash flow at the end of year 3 is approximately $9,932.60.

Therefore, the project's certainty equivalent cash flow for year 3, rounded to the nearest dollar, would be $9,933.