What is the risk-neutral probability of robust recovery

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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?

Reference no: EM132934251

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