Your firm is considering a project that is expected to produce a single cash flow of $2,000 next year. The market beta of the project is 2.2. The equity premium is expected to be 6%, and the
Risk-free rate is 3.8%. What is the maximum amount your firm should be willing to invest in
This project? Round your answer to the nearest dollar.
A)$1,709
B)$1,639
C)$1,841
D)$2,000

Question

Quizplus · Accepted Answer

To find the maximum investment amount, calculate the present value of the expected cash flow using the CAPM to determine the appropriate discount rate. The CAPM formula is: $r = r_f + \beta(r_m - r_f)$, where $r$ is the required return, $r_f$ is the risk-free rate, $\beta$ is the market beta, and $r_m - r_f$ is the equity premium. Plugging in the given values: $r = 3.8\% + 2.2(6\%)$ = $3.8\% + 13.2\%$= 17\%. The present value of the cash flow is then calculated using the formula $PV = \frac{FV}{(1 + r)^n}$, where $FV$ is the future value, $r$ is the discount rate, and $n$ is the number of periods. Since the cash flow is one year away, $n = 1$, and $FV = $2,000$, the calculation is $PV = \frac{2000}{(1 + 0.17)} = \frac{2000}{1.17} \approx $1,709$.

Your Firm Is Considering a Project That Is Expected to Produce