Question

1. In two years, a new restaurant may be
   1. a booming success (15% probability) and earn $200,000;
   2. a moderate success (25% probability) and earn $75,000;
   3. barely survive (30% probability) and earn -$7,000; or
   4. fail entirely (30%) and earn –$70,000.

(Assume the payoffs will all occur at the end of the two years.) The firm's current cost of capital is 9%/year. What would be a risk-neutral and fair price for the restaurant today?

Answer 1

Risk neutral and fair price today= $45,121.20 as follows: