Question 525 income and capital returns, real and nominal returns and cash flows, inflation
Which of the following statements about cash in the form of notes and coins is NOT correct? Assume that inflation is positive.
Notes and coins:
Question 574 inflation, real and nominal returns and cash flows, NPV
What is the present value of a nominal payment of $100 in 5 years? The real discount rate is 10% pa and the inflation rate is 3% pa.
Question 1018 RBA cash rate, monetary policy, foreign exchange rate
RBA Governor Phil Lowe says that when the RBA raises the cash rate (by surprise), the Australian dollar (AUD) tends to:
Question 1019 RBA cash rate, monetary policy, wealth effect
Former RBA Governor Phil Lowe says that when the RBA raise the cash rate, asset prices tend to:
Question 547 PE ratio, Multiples valuation, DDM, income and capital returns, no explanation
A firm pays out all of its earnings as dividends. Because of this, the firm has no real growth in earnings, dividends or stock price since there is no re-investment back into the firm to buy new assets and make higher earnings. The dividend discount model is suitable to value this company.
The firm's revenues and costs are expected to increase by inflation in the foreseeable future. The firm has no debt. It operates in the services industry and has few physical assets so there is negligible depreciation expense and negligible net working capital required.
Which of the following statements about this firm's PE ratio is NOT correct? The PE ratio should:
Note: The inverse of x is 1/x.
Question 990 Multiples valuation, EV to EBITDA ratio, enterprise value
A firm has:
2 million shares;
$200 million EBITDA expected over the next year;
$100 million in cash (not included in EV);
1/3 market debt-to-assets ratio is (market assets = EV + cash);
4% pa expected dividend yield over the next year, paid annually with the next dividend expected in one year;
2% pa expected dividend growth rate;
40% expected payout ratio over the next year;10 times EV/EBITDA ratio.
30% corporate tax rate.
The stock can be valued using the EV/EBITDA multiple, dividend discount model, Gordon growth model or PE multiple. Which of the below statements is NOT correct based on an EV/EBITDA multiple valuation?
Value the following business project to manufacture a new product.
Project Data | ||
Project life | 2 yrs | |
Initial investment in equipment | $6m | |
Depreciation of equipment per year | $3m | |
Expected sale price of equipment at end of project | $0.6m | |
Unit sales per year | 4m | |
Sale price per unit | $8 | |
Variable cost per unit | $5 | |
Fixed costs per year, paid at the end of each year | $1m | |
Interest expense per year | 0 | |
Tax rate | 30% | |
Weighted average cost of capital after tax per annum | 10% | |
Notes
- The firm's current assets and current liabilities are $3m and $2m respectively right now. This net working capital will not be used in this project, it will be used in other unrelated projects.
Due to the project, current assets (mostly inventory) will grow by $2m initially (at t = 0), and then by $0.2m at the end of the first year (t=1).
Current liabilities (mostly trade creditors) will increase by $0.1m at the end of the first year (t=1).
At the end of the project, the net working capital accumulated due to the project can be sold for the same price that it was bought. - The project cost $0.5m to research which was incurred one year ago.
Assumptions
- 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 3% pa.
- All rates are given as effective annual rates.
- The business considering the project is run as a 'sole tradership' (run by an individual without a company) and is therefore eligible for a 50% capital gains tax discount when the equipment is sold, as permitted by the Australian Tax Office.
What is the expected net present value (NPV) of the project?
Question 370 capital budgeting, NPV, interest tax shield, WACC, CFFA
Project Data | ||
Project life | 2 yrs | |
Initial investment in equipment | $600k | |
Depreciation of equipment per year | $250k | |
Expected sale price of equipment at end of project | $200k | |
Revenue per job | $12k | |
Variable cost per job | $4k | |
Quantity of jobs per year | 120 | |
Fixed costs per year, paid at the end of each year | $100k | |
Interest expense in first year (at t=1) | $16.091k | |
Interest expense in second year (at t=2) | $9.711k | |
Tax rate | 30% | |
Government treasury bond yield | 5% | |
Bank loan debt yield | 6% | |
Levered cost of equity | 12.5% | |
Market portfolio return | 10% | |
Beta of assets | 1.24 | |
Beta of levered equity | 1.5 | |
Firm's and project's debt-to-equity ratio | 25% | |
Notes
- The project will require an immediate purchase of $50k of inventory, which will all be sold at cost when the project ends. Current liabilities are negligible so they can be ignored.
Assumptions
- The debt-to-equity 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. Note that interest expense is different in each year.
- Thousands are represented by 'k' (kilo).
- 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 nominal. 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?
Question 418 capital budgeting, NPV, interest tax shield, WACC, CFFA, CAPM
Project Data | ||
Project life | 1 year | |
Initial investment in equipment | $8m | |
Depreciation of equipment per year | $8m | |
Expected sale price of equipment at end of project | 0 | |
Unit sales per year | 4m | |
Sale price per unit | $10 | |
Variable cost per unit | $5 | |
Fixed costs per year, paid at the end of each year | $2m | |
Interest expense in first year (at t=1) | $0.562m | |
Corporate tax rate | 30% | |
Government treasury bond yield | 5% | |
Bank loan debt yield | 9% | |
Market portfolio return | 10% | |
Covariance of levered equity returns with market | 0.32 | |
Variance of market portfolio returns | 0.16 | |
Firm's and project's debt-to-equity ratio | 50% | |
Notes
- Due to the project, current assets will increase by $6m now (t=0) and fall by $6m at the end (t=1). Current liabilities will not be affected.
Assumptions
- The debt-to-equity 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 project is undertaken by a firm, not an individual.
What is the net present value (NPV) of the project?
Four retail business people compete in the same city. They are all exactly the same except that they have different ways of funding or leasing the shop real estate needed to run their retail business.
The two main assets that retail stores need are:
- Inventory typically worth $1 million which has a beta of 2, and;
- Shopfront real estate worth $1 million which has a beta of 1. Shops can be bought or leased.
Lease contract prices are fixed for the term of the lease and based on expectations of the future state of the economy. When leases end, a new lease contract is negotiated and the lease cost may be higher or lower depending on the state of the economy and demand and supply if the economy is:
- Booming, shop real estate is worth more and lease costs are higher.
- In recession, shop real estate is worth less and lease costs are low.
Which retail business person will have the LOWEST beta of equity (or net wealth)?
Question 337 capital structure, interest tax shield, leverage, real and nominal returns and cash flows, multi stage growth model
A fast-growing firm is suitable for valuation using a multi-stage growth model.
It's nominal unlevered cash flow from assets (##CFFA_U##) at the end of this year (t=1) is expected to be $1 million. After that it is expected to grow at a rate of:
- 12% pa for the next two years (from t=1 to 3),
- 5% over the fourth year (from t=3 to 4), and
- -1% forever after that (from t=4 onwards). Note that this is a negative one percent growth rate.
Assume that:
- The nominal WACC after tax is 9.5% pa and is not expected to change.
- The nominal WACC before tax is 10% pa and is not expected to change.
- The firm has a target debt-to-equity ratio that it plans to maintain.
- The inflation rate is 3% pa.
- All rates are given as nominal effective annual rates.
What is the levered value of this fast growing firm's assets?
Question 772 interest tax shield, capital structure, leverage
A firm issues debt and uses the funds to buy back equity. Assume that there are no costs of financial distress or transactions costs. Which of the following statements about interest tax shields is NOT correct?
An analyst is valuing a levered company whose owners insist on keeping a constant market debt to assets ratio into the future.
The analyst is wondering how asset values and other things in her model will change when she changes the forecast sales growth rate.
Which of the below values will increase as the forecast growth rate of sales increases, with the debt to assets ratio remaining constant?
Assume that the cost of debt (yield) remains constant and the company’s asset beta will also remain constant since any expansion (or downsize) will involve buying (or selling) more of the same assets.
The analyst should expect which value or ratio to increase when the forecast growth rate of sales increases and the debt to assets ratio remains unchanged? In other words, which of the following values will NOT remain constant?
An analyst is valuing a levered company whose owners insist on keeping the dollar amount of debt funding fixed. So the company cannot issue or repay its debt, its dollar value must remain constant. Any funding gaps will be met with equity.
The analyst is wondering, as he changes inputs into his valuation, such as the forecast growth rate of sales, then asset values and other things will change. This makes it hard to figure out which values can be held constant and would therefore make good model inputs, rather than outputs which vary depending on the inputs. Assume that the cost of debt (yield) remains constant and the company’s asset beta will also remain constant since any expansion (or downsize) will involve buying (or selling) more of the same assets.
Which of the following values can be assumed to stay constant when projected sales growth increases?
Read these quotes from Adir Shiffman's 26 July 2021 article in the AFR 'Roll up, roll up and make a mint off Amazon sellers'.
"Amazon sellers outsource their warehousing and logistics to the tech giant in a model known as “fulfilled by Amazon”, or FBA. Joining FBA provides access to one of the world’s largest global warehousing operations and even a fleet of Boeing 747 cargo jets. Just as significantly, FBA sellers can much more easily qualify for Amazon’s Prime program, which guarantees free and fast shipping to members."
"Companies want to acquire and integrate a selection, or in business parlance, do a 'roll-up'."
"More than 100 companies are now racing to roll-up FBA sellers, and almost all have launched since 2017. At least a dozen of these boast war chests of more than $US100 million. The largest, Thrasio, was founded in 2018 and has raised more than $US1.7 billion. Thrasio targets businesses with high quality and differentiated products that generate $US1 to $US100 million in revenue annually" (Shiffman, 2021).
If Thrasio's total funds available to spend on the roll up is $1.7 billion, and it's buying targets at price-to-revenue multiples of 2, what's the largest number of firms with $50 million of annual revenue that it could buy?
Below is a table showing GMO's 2016 estimates of different assets' durations, appearing in Slater (2017).
If you were certain that interest rates would fall more than the market expects, into what asset might you allocate more funds?
What effect is being referred to in the following quote from the MARTIN model description?
Economy-wide models also account for feedback between economic variables. For example, an increase in aggregate demand will encourage firms to hire more workers, which raises employment and lowers the unemployment rate. The tightening of the labour market is likely to lead to an increase in wages growth. The resulting increase in household incomes is likely to lead to an increase in consumption, further raising aggregate demand. (Ballantyne et al, 2019)
The name of the effect being referred to is:
Question 1013 book build, initial public offering, capital raising, demand schedule
A firm is floating its stock in an IPO and its underwriter has received the following bids, listed in order from highest to lowest share price:
IPO Book Build Bids | ||
Bidders | Share price | Number of shares |
$/share | millions | |
BidderA | 2.5 | 2 |
BidderB | 2 | 1.5 |
BidderC | 1.5 | 4 |
BidderD | 1 | 3 |
BidderE | 0.5 | 2 |
Suppose that the firm's owner wishes to sell all of their 8 million shares, so no new money will be raised and no money will re-invested back into the firm. Which of the following statements is NOT correct?
Question 1014 book build, initial public offering, capital raising, demand schedule
A firm is floating its stock in an IPO and its underwriter has received the following bids, listed in order from highest to lowest share price:
IPO Book Build Bids | ||
Bidders | Share price | Number of shares |
$/share | millions | |
BidderA | 2.5 | 2 |
BidderB | 2 | 1.5 |
BidderC | 1.5 | 4 |
BidderD | 1 | 3 |
BidderE | 0.5 | 2 |
Suppose that the firm's owner wishes to raise $6 million to expand the business by selling new stock in the initial public offering (IPO). The owner currently holds 8 million stock which are not for sale. Which of the following statements is NOT correct?
Question 625 dividend re-investment plan, capital raising
Which of the following statements about dividend re-investment plans (DRP's) is NOT correct?
A company conducts a 2 for 3 rights issue at a subscription price of $8 when the pre-announcement stock price was $9. Assume that all investors use their rights to buy those extra shares.
What is the percentage increase in the stock price and the number of shares outstanding? The answers are given in the same order.
A firm wishes to raise $50 million now. They will issue 7% pa semi-annual coupon bonds that will mature in 6 years and have a face value of $100 each. Bond yields are 5% pa, given as an APR compounding every 6 months, and the yield curve is flat.
How many bonds should the firm issue?
A firm wishes to raise $30 million now. The firm's current market value of equity is $60m and the market price per share is $20. They estimate that they'll be able to issue shares in a rights issue at a subscription price of $15. Ignore the time value of money and assume that all shareholders exercise their rights. Which of the following statements is NOT correct?
A levered firm has only 2 assets on its balance sheet with the below market values and CAPM betas. The risk free rate is 3% pa and the market risk premium is 5% pa. Assume that the CAPM is correct and all assets are fairly priced.
Balance Sheet Market Values and Betas | ||
Balance sheet item | Market value ($m) | Beta |
Cash asset | 0.5 | 0 |
Truck assets | 0.5 | 2 |
Loan liabilities | 0.25 | 0.1 |
Equity funding | ? | ? |
Which of the following statements is NOT correct?
Question 1045 payout policy, leverage, capital structure, beta
A levered firm has only 2 assets on its balance sheet with the below market values and CAPM betas. The risk free rate is 3% pa and the market risk premium is 5% pa. Assume that the CAPM is correct and all assets are fairly priced.
Balance Sheet Market Values and Betas | ||
Balance sheet item | Market value ($m) | Beta |
Cash asset | 0.5 | 0 |
Truck assets | 0.5 | 2 |
Loan liabilities | 0.25 | 0.1 |
Equity funding | ? | ? |
The firm then pays out all of its cash as a dividend. Assume that the beta and yield on the loan liability remain unchanged. Ignore taxes, transaction costs, signalling, information asymmetries and other frictions.
Which of the following statements is NOT correct? This event led to a:
A levered firm has only 2 assets on its balance sheet with the below market values and CAPM betas. The risk free rate is 3% pa and the market risk premium is 5% pa. Assume that the CAPM is correct and all assets are fairly priced.
Balance Sheet Market Values and Betas | ||
Balance sheet item | Market value ($m) | Beta |
Cash asset | 0.5 | 0 |
Truck assets | 0.5 | 2 |
Loan liabilities | 0.25 | 0.1 |
Equity funding | ? | ? |
The firm then pays off (retires) all of its loan liabilities using its cash. Ignore interest tax shields.
Which of the following statements is NOT correct? All answers are given to 6 decimal places. This event led to a:
Question 871 duration, Macaulay duration, modified duration, portfolio duration
Which of the following statements about Macaulay duration is NOT correct? The Macaulay duration:
Question 872 duration, Macaulay duration, modified duration, portfolio duration
A fixed coupon bond’s modified duration is 20 years, and yields are currently 10% pa compounded annually. Which of the following statements about the bond is NOT correct?
Which of the following statements about bond convexity is NOT correct?
Find the Macaulay duration of a 2 year 5% pa semi-annual fixed coupon bond which has a $100 face value and currently has a yield to maturity of 8% pa. The Macaulay duration is:
Which of the following statements is NOT correct? An inverted US government bond yield curve indicates that:
Question 1000 duration, duration of a perpetuity with growth, needs refinement
An unlevered firm cuts its dividends and re-invests in zero-NPV projects with the same risk as its existing projects. This decreases the dividend yield, but increases the firm's equity's dividend growth rate and duration, while its total required return on equity remains unchanged. The equity can be valued as a perpetuity and the duration of a perpetuity is given below:
###D_\text{Macaulay} = \dfrac{1+r}{r-g}###What will be the effect on the stock's CAPM beta? Assume that there's no change in the risk free rate or market risk premium. The company's equity beta will:
Which of the following statements about vanilla floating coupon bonds is NOT correct? A vanilla floating coupon bond's:
Due to floods overseas, there is a cut in the supply of the mineral iron ore and its price increases dramatically. An Australian iron ore mining company therefore expects a large but temporary increase in its profit and cash flows. The mining company does not have any positive NPV projects to begin, so what should it do? Select the most correct answer.
A newly floated farming company is financed with senior bonds, junior bonds, cumulative non-voting preferred stock and common stock. The new company has no retained profits and due to floods it was unable to record any revenues this year, leading to a loss. The firm is not bankrupt yet since it still has substantial contributed equity (same as paid-up capital).
On which securities must it pay interest or dividend payments in this terrible financial year?
Question 488 income and capital returns, payout policy, payout ratio, DDM
Two companies BigDiv and ZeroDiv are exactly the same except for their dividend payouts.
BigDiv pays large dividends and ZeroDiv doesn't pay any dividends.
Currently the two firms have the same earnings, assets, number of shares, share price, expected total return and risk.
Assume a perfect world with no taxes, no transaction costs, no asymmetric information and that all assets including business projects are fairly priced and therefore zero-NPV.
All things remaining equal, which of the following statements is NOT correct?
You believe that the price of a share will fall significantly very soon, but the rest of the market does not. The market thinks that the share price will remain the same. Assuming that your prediction will soon be true, which of the following trades is a bad idea? In other words, which trade will NOT make money or prevent losses?
Find Candys Corporation's Cash Flow From Assets (CFFA), also known as Free Cash Flow to the Firm (FCFF), over the year ending 30th June 2013.
Candys Corp | ||
Income Statement for | ||
year ending 30th June 2013 | ||
$m | ||
Sales | 200 | |
COGS | 50 | |
Operating expense | 10 | |
Depreciation | 20 | |
Interest expense | 10 | |
Income before tax | 110 | |
Tax at 30% | 33 | |
Net income | 77 | |
Candys Corp | ||
Balance Sheet | ||
as at 30th June | 2013 | 2012 |
$m | $m | |
Assets | ||
Current assets | 220 | 180 |
PPE | ||
Cost | 300 | 340 |
Accumul. depr. | 60 | 40 |
Carrying amount | 240 | 300 |
Total assets | 460 | 480 |
Liabilities | ||
Current liabilities | 175 | 190 |
Non-current liabilities | 135 | 130 |
Owners' equity | ||
Retained earnings | 50 | 60 |
Contributed equity | 100 | 100 |
Total L and OE | 460 | 480 |
Note: all figures are given in millions of dollars ($m).
Find Trademark Corporation's Cash Flow From Assets (CFFA), also known as Free Cash Flow to the Firm (FCFF), over the year ending 30th June 2013.
Trademark Corp | ||
Income Statement for | ||
year ending 30th June 2013 | ||
$m | ||
Sales | 100 | |
COGS | 25 | |
Operating expense | 5 | |
Depreciation | 20 | |
Interest expense | 20 | |
Income before tax | 30 | |
Tax at 30% | 9 | |
Net income | 21 | |
Trademark Corp | ||
Balance Sheet | ||
as at 30th June | 2013 | 2012 |
$m | $m | |
Assets | ||
Current assets | 120 | 80 |
PPE | ||
Cost | 150 | 140 |
Accumul. depr. | 60 | 40 |
Carrying amount | 90 | 100 |
Total assets | 210 | 180 |
Liabilities | ||
Current liabilities | 75 | 65 |
Non-current liabilities | 75 | 55 |
Owners' equity | ||
Retained earnings | 10 | 10 |
Contributed equity | 50 | 50 |
Total L and OE | 210 | 180 |
Note: all figures are given in millions of dollars ($m).
Acquirer firm plans to launch a takeover of Target firm. The deal is expected to create a present value of synergies totaling $105 million. A cash offer will be made that pays the fair price for the target's shares plus 75% of the total synergy value. The cash will be paid out of the firm's cash holdings, no new debt or equity will be raised.
Firms Involved in the Takeover | ||
Acquirer | Target | |
Assets ($m) | 6,000 | 700 |
Debt ($m) | 4,800 | 400 |
Share price ($) | 40 | 20 |
Number of shares (m) | 30 | 15 |
Ignore transaction costs and fees. Assume that the firms' debt and equity are fairly priced, and that each firms' debts' risk, yield and values remain constant. The acquisition is planned to occur immediately, so ignore the time value of money.
Calculate the merged firm's share price and total number of shares after the takeover has been completed.
Acquirer firm plans to launch a takeover of Target firm. The deal is expected to create a present value of synergies totaling $0.5 million, but investment bank fees and integration costs with a present value of $1.5 million is expected. A 10% cash and 90% scrip offer will be made that pays the fair price for the target's shares only. Assume that the Target and Acquirer agree to the deal. The cash will be paid out of the firms' cash holdings, no new debt or equity will be raised.
Firms Involved in the Takeover | ||
Acquirer | Target | |
Assets ($m) | 60 | 10 |
Debt ($m) | 20 | 2 |
Share price ($) | 10 | 8 |
Number of shares (m) | 4 | 1 |
Assume that the firms' debt and equity are fairly priced, and that each firms' debts' risk, yield and values remain constant. The acquisition is planned to occur immediately, so ignore the time value of money.
Calculate the merged firm's share price and total number of shares after the takeover has been completed.
A man just sold a call option to his counterparty, a lady. The man has just now:
A European put option will mature in ##T## years with a strike price of ##K## dollars. The underlying asset has a price of ##S## dollars.
What is an expression for the payoff at maturity ##(f_T)## in dollars from owning (being long) the put option?
Question 432 option, option intrinsic value, no explanation
An American style call option with a strike price of ##K## dollars will mature in ##T## years. The underlying asset has a price of ##S## dollars.
What is an expression for the current intrinsic value in dollars from owning (being long) the American style call option? Note that the intrinsic value of an option does not subtract the premium paid to buy the option.
After doing extensive fundamental analysis of a company, you believe that their shares are overpriced and will soon fall significantly. The market believes that there will be no such fall.
Which of the following strategies is NOT a good idea, assuming that your prediction is true?
Question 636 option, option payoff at maturity, no explanation
Which of the below formulas gives the payoff ##(f)## at maturity ##(T)## from being long a call option? Let the underlying asset price at maturity be ##S_T## and the exercise price be ##X_T##.
Which of the below formulas gives the profit ##(\pi)## from being short a call option? Let the underlying asset price at maturity be ##S_T##, the exercise price be ##X_T## and the option price be ##f_{LC,0}##. Note that ##S_T##, ##X_T## and ##f_{LC,0}## are all positive numbers.
Which of the following statements about call options is NOT correct?
A trader just bought a European style put option on CBA stock. The current option premium is $2, the exercise price is $75, the option matures in one year and the spot CBA stock price is $74.
Which of the following statements is NOT correct?
Question 584 option, option payoff at maturity, option profit
Which of the following statements about European call options on non-dividend paying stocks is NOT correct?
A stock, a call, a put and a bond are available to trade. The call and put options' underlying asset is the stock they and have the same strike prices, ##K_T##.
You are currently long the stock. You want to hedge your long stock position without actually trading the stock. How would you do this?
Question 271 CAPM, option, risk, systematic risk, systematic and idiosyncratic risk
All things remaining equal, according to the capital asset pricing model, if the systematic variance of an asset increases, its required return will increase and its price will decrease.
If the idiosyncratic variance of an asset increases, its price will be unchanged.
What is the relationship between the price of a call or put option and the total, systematic and idiosyncratic variance of the underlying asset that the option is based on? Select the most correct answer.
Call and put option prices increase when the:
A company runs a number of slaughterhouses which supply hamburger meat to McDonalds. The company is afraid that live cattle prices will increase over the next year, even though there is widespread belief in the market that they will be stable. What can the company do to hedge against the risk of increasing live cattle prices? Which statement(s) are correct?
(i) buy call options on live cattle.
(ii) buy put options on live cattle.
(iii) sell call options on live cattle.
Select the most correct response:
A trader buys one crude oil European style call option contract on the CME expiring in one year with an exercise price of $44 per barrel for a price of $6.64. The crude oil spot price is $40.33. If the trader doesn’t close out her contract before maturity, then at maturity she will have the:
A trader buys one crude oil European style put option contract on the CME expiring in one year with an exercise price of $44 per barrel for a price of $6.64. The crude oil spot price is $40.33. If the trader doesn’t close out her contract before maturity, then at maturity she will have the:
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?
A one year European-style call option has a strike price of $4. The option's underlying stock pays no dividends and currently trades at $5. The risk-free interest rate is 10% pa continuously compounded. Use a single step binomial tree to calculate the option price, assuming that the price could rise to $8 ##(u = 1.6)## or fall to $3.125 ##(d = 1/1.6)## in one year. The call option price now is:
A 12 month European-style call option with a strike price of $11 is written on a dividend paying stock currently trading at $10. The dividend is paid annually and the next dividend is expected to be $0.40, paid in 9 months. The risk-free interest rate is 5% pa continuously compounded and the standard deviation of the stock’s continuously compounded returns is 30 percentage points pa. The stock's continuously compounded returns are normally distributed. Using the Black-Scholes-Merton option valuation model, determine which of the following statements is NOT correct.