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Question 4. (20 points) A risk-neutral entrepreneur contemplates an irre- versible investment of / = $510 min. The project will generate a constant stream of

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Question 4. (20 points) A risk-neutral entrepreneur contemplates an irre- versible investment of / = $510 min. The project will generate a constant stream of revenues of $150 min. annually starting a year after the invest- ment has been made. The current operating cost is SC min. per year. In a year from now, the operating cost may go up or down by 10% and will remain constant thereafter. Assume that risk-neutral probabilities of each event are 0.5. There is no operating cost to be paid until the project starts generating revenues. The annual risk free interest rate is r = 0.1. (a) (5 points) What is the expected present value (EPV) of immediate in- vestment as a function of C? DO Vo,o (C) = 0.5 150 - 1.10 + 150 - 0.90 1.1t 1.1t - 510 = 0.5 150 - 1.10 150 - 0.90 0.1 0.1 - 510 = 990 - 100, provided C 99. (b) (5 points) What is the EPV of investment at t = 1 as a function of O? Vi,I(110) = 150 - 1.10 - 510 = 990 - 110 if C 90. Vi,1 (0.90) = 150 - 0.90 990 - 90 if C 110. Hence, 990-100 1.1 if C 110

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