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Finish this question. (Corporate Finance) Â Â Â Â

I. Short answer:

1. What are the perfectmarket assumptions?

2. Explain whether the following statements are true or false. In each case,

provide justification for your answer:

â€¢ In a perfect capital market, expected returns on all bonds must be

equal to the risk-free (T-bill) rate.

â€¢ In a perfect capital market with risk-neutral investors, expected returns

on all bondsmust equal the risk-free rate.

3. Write down the CAPM formula. What are the economy-wide inputs and

what are the firm-specific inputs?

II. The table below describes the return rates for a stock X and a market index

fund, call itM. Find the (true, as opposed to estimated) beta of stock X. Assume

the probability of the â€œgoodâ€ state is 1/3 (â€œbadâ€ has probability 2/3).

Good Bad

M 10% 6%

Asset X 4% 10%

III. Suppose Intelâ€™s stock has an expected return of 10%and a volatility (standard

deviation) of 5%, while Coca-Colaâ€™s has an expected return of 5% and volatility

of 2%. Assume these two stocks have correlation coefficient âˆ’1.

1. Calculate the portfolio weights that remove all risk.

2. If there are no arbitrage opportunities, what is the risk-free rate of interest

in this economy?

IV. A biotech company has a drug in development that will allow you to sell your

firm for $10 billion next year. Assume your boss wants you to use the CAPM.

Your firm has a beta of 4, the risk-free rate is 5% per year, and the equity premiumis

2% per year. What do you think the firmis worth today?

V. Your borrowing rate is 15% per year. Your lending rate is 5% per year. The

project costs $1,000 and has a rate of return of 10%.

1. Assume you have $500 of your own money to invest. Should you invest in

this project?

1

2. Find themaximal amount the investor would bewilling to borrow in order

to invest in the project?1

VI. Option pricing:

1. Consider a European call option on a single share of stock in company

X. The strike price is $25 and the maturity date is 1 year. Call this a â€œ25-

callâ€ for simplicity (and, generally, a â€œKâ€-call, where K is the strike price).

Draw the payoff diagram in the two cases where (i) an investor goes long

on a single 25-call, and (ii) an investor shorts both a 25-call and a 20-call.

2. Consider (European) call and put options on a single share of stock in

company X. Each has a strike price of $25 and matures in 1 year. Assume

the (per share) stock price at the time the options are written is $22 and

that the cost of the put is $2. Also assume that the risk-free rate is 10%.

Find the price of the call.

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