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A project has an expected risky cash flow of $500 in year 2. The risk-free rate is 4 percent, the expected market rate of return is 14 percent, and the project's beta is 1.20. Calculate the certainty equivalent cash flow for year 2, CEQ2.

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Answer: $401.90

Explanation:

The Certainty equivalent cash flow is essentially the risk-free cashflow of a project.

The Certainty equivalent cashflow here therefore will be the future value of the investment given using the risk-free rate.

Investment = Present value of $500 using the required rate.

Required rate using CAPM is;

= Risk-free rate + beta * (Market rate - risk-free rate)

= 4% + 1.20 * (14% - 4%)

= 4% + 12%

= 16%

Investment = 500 / ( 1 + 16%)²

= $371.58

Future value in year 2 using Risk-free rate;

= 371.58 * ( 1 + 4%)²

= $401.90

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