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Question - Your friend just made an investment of $80 million in his business anticipating a recovery in Australian economy post-covid vaccination. However, given the uncertainties, he is unsure of a robust recovery. The following binomial tree represents his view of what his firm will be worth in a years-time.
$125 million
Robust recovery:
$100 million
Status quo $80 million
Given the uncertainly, he is willing to sell the firm to you at a price of $90 million. You may take up the offer any time between now and one-year from now. Using Binomial pricing model, value this real option. You may assume a risk free rate of 5% per annum.
a) Draw a binomial tree showing the option values for the two states of the economy.
b) What is the risk-neutral probability of robust recovery?
c) What type of option do you have? Compute its value as of now (t=0).
d) Assume that in the robust state you receive cash flows of $12.5 million from the business. Cash flows are only $8million if status quo prevails what would be the option value with these additional assumptions?
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