Laura Drake wishes to estimate the value of an asset expected to provide cash inflows of $3,000 per year at the end of years 1 through 4 and $15,000 at the end of year 5. Her research indicates that she must earn 10% on low-risk assets, 15% on average-risk assets, and 22% on high-risk assets.
a. Determine what is the most Laura should pay for the asset if it is classified as
(1) Low-risk,
(2) Average-risk, and
(3) High-risk.
b. Suppose Laura is unable to assess the risk of the asset and wants to be certain she’s making a good deal. On the basis of your findings in part a, what is the most she should pay? Why?
c. All else being the same, what effect does increasing risk have on the value of an asset? Explain in light of your findings in part a.