You're thinking of investing in a project owned by another firm. You are asked to make an investment as a senior debt holder. The firm is asking for a loan (face value) of 75% of the value of the project asset value with a stated simple interest rate of 8%. The term of the loan will be one year, with an interest payment plus the face value of debt due at the end of the year. This investment would be senior to all other claims on the project, so you would be entitled to the full value of the project in the event of default. The facts of the project are:

• The project is currently producing cash flows of $500,000 per year and is expected to do so in perpetuity.
• The project is valued at a discount rate of 8%.
• The risk free rate is 5%
• The volatility of the underlying cash flows is estimated at =35%

Use a two-step binomial model (i.e. two steps for one year) to answer the following questions.

1. What is value of your investment opportunity (i.e., the value of the debt claim on the project)? Should you make the loan?
2. How does the value of this investment opportunity change with the underlying volatility of the project? Why?