Question: A small engineering firm is commencing trials for a new battery technology. These trials will take one year to complete. The firm's shares are currently

A small engineering firm is commencing trials for a new battery technology. These trials will take one year to complete. The firm's shares are currently trading at $12 per share. The firm does not pay dividends and is not expected to do so in the next two years. If the trials are unsuccessful, the firm will be closed, and its patents sold for $5 per share. If the trials are successful, its share price will increase to $27.35 and the firm will need to apply for regulatory approval, which will require further trials that will take one year to complete. If the firm is successful in obtaining regulatory approval, the firm will be sold to a major technology company for $55 per share. If approval is not gained, the firm will be closed, and its patents sold for $15 per share. At each stage, the probability of success is the same. The firm has zero systematic risk. The risk-free rate is 3% per year and the market risk premium is 6%. (f) What is the value of a security that pays $1 if the firm secures regulatory approval in the next two years, and otherwise pays zero? Explain.

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