I am buying a firm with an expected perpetual cash flow of $1,450 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 5% and the expected rate of return on the market is 20%. (Input the amount as a positive value.)

Question

Steven Lewis

Business

10 March, 18:50

I am buying a firm with an expected perpetual cash flow of $1,450 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 5% and the expected rate of return on the market is 20%. (Input the amount as a positive value.)

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Felipe Robinson · Answer 1

Thus amount extra offered = $29,000 - $7,250 = $21,750

Explanation:

Calculating true worth of company

Cash flow = Rf + beta (Rm - Rf)

Where Cash flow = $1,450

Rf = Risk free rate of return = 5%

Rm = Rate of return of market = 20%

Calculating true worth of company

$1450 = 5% + 1 X (20% - 5%)

$1450 = 5% + 15%

$1450 = 20%

Value of company = $1450/20% = $7,250

In case value of Beta is taken as 0 then

$1450 = 5% + 0 (20% - 5%)

$1450 = 5%

Value of company = $1450/5% = $29,000

Thus amount extra offered = $29,000 - $7,250 = $21,750