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Suppose an entrepreneur is creating a new firm and has a single project requiring an...

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Finance

Suppose an entrepreneur is creating a new firm and has a single project requiring an initial investment of $100 today.

In one year, if the demand for the firms product is strong, the project will generate a cash flow of $990. If demand for the firms product is weak, the project will generate a cash flow of $110. The probability of the good state is 25% and the probability of the bad state is 75%.

The risk-free rate is 5% APR with annual compounding and investors require a risk premium of 5% APR with annual compounding in order to invest in this new firm. Thus, the cost of capital for this firm is 10% APR with annual compounding. This company plans to finance itself by issuing $100 of debt maturing in one year with 5% interest rate and finance the remainder with equity. The firm plans to have 25 shares outstanding.

Based on this information, the expected share price is closest to which of the following amounts?

$4

$8

$40

$80

$100

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