Fight Finance

The security market line (SML) shows the relationship between beta and expected return.

Buying investment projects that plot above the SML would lead to:

You have just sold an 'in the money' 6 month European put option on the mining company BHP at an exercise price of $40 for a premium of $3.

Which of the following statements best describes your situation?

Notes

1. Due to the project, current assets will increase by $5m now (t=0) and fall by $5m at the end (t=1). Current liabilities will not be affected.

Assumptions

• The debt-to-assets ratio will be kept constant throughout the life of the project. The amount of interest expense at the end of each period has been correctly calculated to maintain this constant debt-to-equity ratio.
• Millions are represented by 'm'.
• All cash flows occur at the start or end of the year as appropriate, not in the middle or throughout the year.
• All rates and cash flows are real. The inflation rate is 2% pa.
• All rates are given as effective annual rates.
• The 50% capital gains tax discount is not available since the project is undertaken by a firm, not an individual.

What is the net present value (NPV) of the project?

A risky firm will last for one period only (t=0 to 1), then it will be liquidated. So it's assets will be sold and the debt holders and equity holders will be paid out in that order. The firm has the following quantities:

##V## = Market value of assets.

##E## = Market value of (levered) equity.

##D## = Market value of zero coupon bonds.

##F_1## = Total face value of zero coupon bonds which is promised to be paid in one year.

What is the payoff to debt holders at maturity, assuming that they keep their debt until maturity?

You own some nice shoes which you use once per week on date nights. You bought them 2 years ago for $500. In your experience, shoes used once per week last for 6 years. So you expect yours to last for another 4 years.

Your younger sister said that she wants to borrow your shoes once per week. With the increased use, your shoes will only last for another 2 years rather than 4.

What is the present value of the cost of letting your sister use your current shoes for the next 2 years?

Assume: that bank interest rates are 10% pa, given as an effective annual rate; you will buy a new pair of shoes when your current pair wears out and your sister will not use the new ones; your sister will only use your current shoes so she will only use it for the next 2 years; and the price of new shoes never changes.

The Australian cash rate is expected to be 2% pa over the next one year, while the US cash rate is expected to be 0% pa, both given as nominal effective annual rates. The current exchange rate is 0.73 USD per AUD.

What is the implied 1 year USD per AUD forward foreign exchange rate?

A stock’s current price is $1. Its expected total return is 10% pa and its long term expected capital return is 4% pa. It pays an annual dividend and the next one will be paid in one year. All rates are given as effective annual rates. The dividend discount model is thought to be a suitable model for the stock. Ignore taxes. Which of the following statements about the stock is NOT correct?

A real estate agent says that the price of a house in Sydney Australia is approximately equal to the gross weekly rent times 1000.

What type of valuation method is the real estate agent using?

A common phrase heard in financial markets is that ‘high risk investments deserve high returns’. To make this statement consistent with the Capital Asset Pricing Model (CAPM), a high amount of what specific type of risk deserves a high return?

Investors deserve high returns when they buy assets with high:

A bank sells a European call option on a non-dividend paying stock and delta hedges on a daily basis. Below is the result of their hedging, with columns representing consecutive days. Assume that there are 365 days per year and interest is paid daily in arrears.

In the last column when there are 55 days left to maturity there are missing values. Which of the following statements about those missing values is NOT correct?