Question

I am buying a firm with an expected perpetual cash flow of $700 but am unsure of its risk. If I think the beta of the firm is 0, when the beta is really 1, how much more will I offer for the firm than it is truly worth? Assume the risk-free rate is 7% and the expected rate of return on the market is 14%. (Input the amount as a positive value.)

Answer 1

$50

Step-by-step explanation:

using the CAPM,

The expected rate of return = risk free rate + beta(market rate of return - risk free rate)

if beta is 0,

7% + 0 X(14% - 7%) = 7%

If beta is 1,

7% + 1 X(14% - 7%) = 14%

Present value of a perpetuity = amount / expected rate of return

if beta is 0, present value = $700 / 7% = $100

if beta is 1, present value = $700 / 14% = $50

the amount offered will differ by $100 - $50 = $50