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FINANCIAL SECURITY VALUATION
There are two questions. Each question carries 50 points.
1. This question has three parts:
i. You would like to estimate the cost of capital for a new airline business. Based on its industry asset beta, you have already estimated an unlevered cost of capital for the firm of 9%. However, the new business will be 25% debt financed, and you anticipate its debt cost of capital will be 6%. If its corporate tax rate is 40%, what is your estimate of its cost of capital? (20 points)
ii. The current price of Pineapple stock is $50. In each of the next two years, this stock price can either go up by $19 or go down by $11. The stock pays no dividends. The one-year risk-free interest rate is 4% and will remain constant.
a) Using the Binomial Model, calculate the price of a two-year put option on Pineapple stock with a strike price of $49. (8 points)
b) Using the Binomial Model, calculate the price of a two-year call option on Pineapple stock with a strike price of $51. (7 points)
iii. Assume first that the interest rate for all horizons is 5%.
a) What is the price of a 5-year coupon bond that pays $200 for 4 years and $1,600 in the fifth year? What is its duration? What is the modified duration of this bond? (3 points)
b) Let us assume that the interest rate changes by 25 basis point from 5% to 5.25%, what is the convexity and how the presence of convexity affects the resulting change in its price? (3 points)
c) Let us assume that the interest rate changes by 100 basis points from 5% to 6%, how the presence of convexity affects the resulting change in its price? Compare it with part iii and explain the results. (4 points)
d) As CFO of a leading bank, how do interest rate change affect your balance sheet? Hint: think of your balance sheet and debt interest payments on varying maturities of debt. (5 points)
2. This question has three parts:
i. Pineapple stock has a volatility of 30% and a current stock price of $50 per share. Pineapple pays no dividends. The risk-free interest is 4%.
a) Determine the Black-Scholes value of a one-year, at-the-money call option on Pineapple stock. (5 points)
b) What is the impact on the value of this call option when the volatility of the stock goes up by 5% to 35%. Explain your result. (5 points)
c) What is the impact on the value of this call option when the interest rates go up by 1% to 5%. Explain your result. (5 points)
d) What is the impact on the value of this call option when three months elapse, with no other change. Explain your result. (5 points)
ii. Jonnie Depp Productions (JDP), suspended its dividend at the start of 2009 and as of the middle of 2012, has not reinstated its dividend. Suppose you do not expect JDP to resume paying dividends until July 2014. You expect JDP’s dividend in July 2014 to be $1.20 (paid annually), and you expect it to grow by 6% per year thereafter. If JDP’s equity cost of capital is 10%, what is the value of a share of JDP in July 2012? Explain your result. (15 points)
iii. A 6% five-year bond yields 15% and a 10% five-year bond yields 10%. Calculate the fifth-year spot rate. Assume annual coupon payments. Explain your result. (15 points)