1. Replicating portfolio

Assume that you have an investment opportunity to start a car factory that will cost 230 million next year. The expected cash flow is either 340 million or 130 million with an equal probability. The risk free rate is 8%.

Required;

1. Assume there exists a perfectly correlated security (or commodity in this example) that trades in the market for 40 per share (or unit). Its payouts (68 and 26) equal one-fifth of the payouts of the project with an equal probability, and its expected return equals the underlying projects cost of capital. Use this information to create a replicating portfolio and estimate the value of the projects with options.