At the end of chapter 22 there is an example of how to value real options. The risk neutral probability of success is calculated, given the PV at outset (7m) and the PVs and the end of year one if the project is a success (9m) or a flop (4m). In practice the 9m and 4m can be calculated by looking at the expected cashflows under the two scenarios (success and flop). How will the 7m PV at outset be calculated? In the example it is just a given number. Thanks.
Risk neutral Hi, I think this question probably goes slightly beyond what appears to come up in SA5 exams (with the benefit of hindsight). The 7m is the PV of the two outcomes using appropriate risk discount rates and real probabilities for each of the two outcomes. So 9* (prob of success) * (1.15)^-1 + 4 * (prob of failure) * (1.15)^-1 would be a typical calculation, where I have selected 15% as a reasonable discount rate.
