Consider a project that in one year pays $50 if the economy performs well (the stock market goes up) and that pays $100 if the economy performs badly (the stock market goes down). The probability of the economy performing well is 60%, the effective annual risk-free rate is 6%, the expected return on the market is 10%, and the beta of the project is −0.50.
a. Compute the present value of the project’s cash flows using the true probabilities and expected return on the project.
b. Compute the risk-neutral probability of the economy performing well, then repeat the valuation of the project using risk-neutral valuation.