Question

The Terra Firma Corporation is considering an investment into the aluminium industry that has a beta of 1.25. The risk-free rate is 3% and the average return on the market index is 7%. Assume that an investment of $100 into this industry has zero net present value if carried out today. The investment cost of $100 will remain constant over the next two years, but the present value of the investment will, each year, increase by 20% with probability one half and reduce by 4% with probability one half. An investment in this industry will not generate cash flows for the first two years of its duration.

1. Explain what we mean by risk neutral probabilities.                                             

2. Find the risk neutral probabilities for the Binomial process described above?       

3. Outline the optimal timing of the investment into this industry, making your decision contingent on the evolution of the present value of the investment. You should restrict your planning horizon to two years (which is as long as the investment cost remains constant).    

4. What is the net present value of the optimal investment plan outlined in question (c), per $100 investment?   

e.Give three real-world examples in corporate finance where option pricing theory is essential for analysing net present value.

Answer 1

Answer to first question

Risk neutral probabilities

When an individual or a company makes an investment, it often does not consider future returns with many risks involved. These risks can be in any form- natural disaster, economic recession, etc. The individual or the company often estimates the future returns according to the trend of present market scenario and when these scenarios changes with risks involved, the returns too alter. Therefore, it is important to make risk neutral probabilities.

Risk neutral probabilities is nothing but computing future returns after considering various risks that can be involved. Probable Returns might show less then expected but the fact that it has accounted for the risks makes them more safer and thus helps an individual or a company to decide their investment.