Consider a risky portfolio. The end-of-year cash flow derived from the portfolio

Question

Consider a risky portfolio. The end-of-year cash flow derived from the portfolio will be either $70,000 or $180,000, with equal probabilities of 0.5. The alternative riskless investment in T-bills pays 4%. a. If you require a risk premium of 12%, how much will you be willing to pay for the portfolio? (Round your answer to the nearest dollar amount.) Value of the portfolio b. Suppose the portfolio can be purchased for the amount you found in (a). What will the expected rate of return on the portfolio be? (Do not round intermediate calculations. Round your answer to the nearest whole percent.) Rate of return c.Now suppose you require a risk premium of 16%. What is the price you will be willing to pay now? (Round your answer to the nearest dollar amount.) Value of the portfolioS

Explanation / Answer

a)

expected cash flow from portfolio = 0.5 * 70000 + 0.5 * 180000 = 125000

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

required return of portfolio = 4% + 12% = 16%

Amount of investment * (1+r) = expected cash flows from portfolio

=>

Amount of investment = 125000/1.16 = 107758.62

b)

rate of return = (expected cash flows from portfolio - amount of investment)/amount of investment

= 125000 - 107758.62/107758.62

= 16%

c)

required rate of return = 4% + 16% = 20%

=>

amount of investment = 125000/1.2

= 104166.67

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