Problem 2:

You have an idea for a new product that will generate future cash flows that are correlated with general market conditions (i.e., when the economy is doing well, the cash flows will usually be higher than average and when the economy is slumping, the cash flows will usually be below average).In particular, you have estimated that the correlation in the cash flow returns from your new product and the return on the market is .75.You have also estimated that the standard deviation of the return on your new product is .15 (15%).The current estimate of the standard deviation of market returns is .20 (20%).The risk-free rate is .02.You have also estimated that after the first year, your new product will produce $150,000 in cash flow (at the end of the year) on average; beyond that, you expect that the average cash flow will grow 3% per year indefinitely.Letdenote the risk-free rate (e.g., for 2%).

1.Based on a market risk premium of 07 (7%) and the data above, what is the present value of the expected stream of future cash flows from your new product.First calculate the beta of the new project and the required rate of return given that beta according to CAPM.Using the present value of a growing perpetuity formula, calculate the present value of the stream of growing cash flows, discounting at the required rate of return implied by CAPM.

2.If it costs $4,000,000 to develop and implement this new product, do you want to go forward and spend the $4,000,000?

3.Sensitivity Analysis:Do you want to go forward if the growth rate in the average cash flow is only .01 (1%)?What if the market risk premium is only .06 (6%)?