8006 Exam Dumps : Exam I: Finance Theory Financial Instruments Financial Markets - 2015 Edition

The operating free cash flows can be considered a perpetual annuity with a given growth rate.

The value of a perpetuity of a periodic cash flow of 'c', with a discount rate 'r' and growth rate 'g' is given by c/(r - g). In the given case, the company can be considered as providing a perpetual annuity which provides an annual cash flow of $100 which are growing at 2.5% (equal to the GDP's growth rate, as given), and whose cost of capital, or the discount rate to use, is 7.5%

Therefore the value of the firm in this case is given by $100/(7.5% - 2.5%) = $2,000. Recall that the value of the firm is equal to the Operating Free Cash Flow/Weighted Average Cost of Capital (OFCF/WACC). Therefore Choice 'd' is the correct answer.

The put-call parity can be expressed as:

Call – Put = Spot – PV of exercise price

Note that a negative sign above means a short position. The 'term PV of exercise price' is the same as a bank deposit placed today equivalent to the PV of the exercise price so that we will have the cash flow on the exercise date to exercise the option.

Therefore only Choice 'd' is the correct answer as rearranging the above gives us Buying a call + Bank Deposit = Buying the stock + Buying a put.

Choice 'd' is therefore the correct answer.

This question requires us to use the CAPM.

Recall that according to CAPM the expected return on an asset = The risk free rate + β x Market risk premium.

Using the beta and expected return of security A, we can determine the market risk premium to be (8% - 3%)/1.2 = 4.1667%. The excess return is the return over the risk free rate, and for security B, this is nothing but the beta multiplied by the market risk premium. Therefore the correct answer is 4.1667% x 1.5 = 6.25%. Note that this is the 'excess return', and not the total return. (Total return will include the risk free rate).