Questions 1 – 6 carry equal marks of 13 each, question 7 carries 22 marks. Answer all questions

Q1. Answer the following questions.

a. What is the Optimal Capital Structure? Explain with a graph.

b. What is diversification in Finance? Explain.

c. Explain the differences between American and European options.

Q2. Provide appropriate answers to the following questions.

a. What are differences between future and forward contracts? Explain.

b. Explain 3 forms of market efficiencies.

c. Explain the term structure of interest rates.

Q3. If government bonds are currently paying 7 per cent and the inflation rate is 2.1 per cent, what is the approximate real rate? What is the exact real rate?

Q4. The following information relates to Rio Tinto Mining Corporation. What is Rio Tinto’s weighted average cost of capital?

? 10 years ago, Rio Tinto issued 80,000 bonds with 16 years maturity and a face value of $1000 each, pays an – annual coupon amount of $100 each. The yield on the bonds is 15% p.a. Rio Tinto’s marginal corporate tax rate is 30%.

? Rio Tinto has 15 million preference shares on issue, which are currently trading for $3.20 each, giving total market value of $48 million. They pay an annual dividend of 30 cents per share.

? Rio Tinto has 21.5 million ordinary shares on issue, which are currently trading for $4 each. These shares are expected to pay an annual dividend of $0.75 next year, and this dividend is expected to grow at the constant rate of 3% in perpetuity.

Q5. Use the following option quotes to answer the questions below.

December, 2019, Alibaba Ltd

Last sale price $16.00

Calls – Last Puts – Last

Strike Price Jun July Aug Jun July Aug

$16.00 36 cents 48 cents 72 cents 24 cent 27 cents 32 cents

a. Suppose you buy 150 July $16.00 call contracts. How much will you pay, ignoring commissions?

b. Suppose you buy 50 of August 2019 put contracts. What is your maximum net gain?

On the expiration date, Alibaba is selling for $14.00 per share. What are your options worth?

c. In part (b), suppose you sold your 50 August put contracts. What is your net gain or loss if Alibaba is selling for $13.00?

Q6. You would like to invest in two shares A and B. The return on these shares over the next year depends on the state of economy, which will be described as “Boom”, “Normal”, “Slow” and “Recession”. The table below shows the probability of each of these states of economy, and the expected return on each share given each possible state of the economy. The correlation coefficient between shares A and B is 0.5.

State of the economy Probability A Return B Return

Boom 0.20 0.25 0.21

Normal 0.40 0.16 0.12

Slow 0.25 0.10 0.08

Recession 0.15 – 0.06 0.05

a. What is the expected return on A and B shares?

b. What is the standard deviation of A and B shares?

c. What is the expected return on portfolio comprised of 55% invested in share A and the balance in share B?

d. What is the standard deviation on portfolio comprised of 55% invested in share A and 45% invested in share B?

Q7. The risky portfolio Q consists of 2,500 shares of Google and 7,500 shares of Yahoo. Assume that Google has a share price of $4, an expected return of 18 per cent, and a standard deviation of 25 per cent. Yahoo has a share price of $2, an expected return of 15 per cent, and a standard deviation of 20 per cent. The correlation between the two is 0.5, and the risk-free rate of interest is 2 per cent.

What fraction of your portfolio must you invest in risky portfolio of Q and risk-free to have a portfolio standard deviation of 12 per cent?