Consider a stock with a 50 percent probability of zero net earnings and a 50 percent probability of net earnings equal to $20 per share each year continuously in the future. Furthermore, assume that people are risk averse. That is, they will have to be compensated for uncertainty accompanying variation in their future wealth. If the interest rate were 5 percent, how much would people be willing to pay for a share of this stock?
A) $10
B) $200
C) less than $200
D) more than $200
E) $400

Question

Quizplus · Accepted Answer

The expected earnings per share is $10 ($0 * 0.5 + $20 * 0.5). The present value of a perpetuity with $10 annual earnings at a 5% interest rate is $200 ($10 / 0.05). However, due to risk aversion, people would pay less than $200.

Consider a Stock with a 50 Percent Probability of Zero