Draw the binomial tree for the cash flow development

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Reference no: EM132172618

Question - Assume discrete interest rates throughout the section!

Arminia Leipzig is a second league soccer club with very limited financial possibilities. At the moment, they consider to buy the world famous defender Mike Sledgehammer. His current club demands EUR 1 million for Mr. Sledgehammer who is at the end of his career, but willing to play two more years (T = 2 years) for Leipzig. The payoffs of the potential deal are uncertain for Arminia Leipzig as they heavily depend on health and performance of Mr. Sledgehammer.

The soccer club's manager has looked at many other similar transfer deals and also revisited his documents from basic finance classes at university. He concludes that a two-step binomial model best describes the uncertain cash flows the club faces. There is an immediate cash flow in t-0 of EUF 400,000 caused by merchandising sales and new sponsors. Afterwards, the cash flow in each period can either go up with a factor of 2.0 or go down with a factor of 0.5. The risk-free rate (rf) is 4%.

1. Draw the binomial tree for the cash flow development!

2. What is the risk-neutral probability (q) to move up in the tree?

3. Calculate the present value of Mr. Sledgehammer for Arminia Leipzig. Should they buy the player?

Reference no: EM132172618

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