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25-08-2018

Product code: Accounts-AW410

PART II

Answer 2 of the following questions.

1. The company BETARIX is an investment company (actually like a mutual

fund) that has the following balance sheet:

BETARIX Ltd

Assets Liabilities

• Bonds for 100.000 EUR (market value) a 100% equity financed © 1000 units of stocks of Valuax Ltd (500 units of stocks issued)

- The bonds owned by Betarix Ltd are government bonds and their beta is for simplicity assumed to be zero. The duration of the bond is 4 years.

- Betarix also owns stocks of Valuax. Valuax is a company with an expected dividend of 10 EUR the next year. The expected growth rate of its dividends is 2% annually from the next year onwards. The markets risk-adjusted rate of return requirement for the Valuax stock is 8% p.a. The Valuax stock has a beta of 0.8.

1.) Compute the market value of one stock of Betarix. Also: what would its beta be?

(Hint: For the price of the Valuax stock, use the Gordon formula. For beta, use the rule on page 20, only this turn for the other side of the balance sheet.)

2.) Assume that interest rates in the economy go up by 1%. Prior to this, the bond yield was 4% and the rate-of-return requirement for the Valuax stock 8%. Now each of these goes up by 1%. Compute approximately what the percentage change in the market value of Betarix would be.

3.) Assume now that Betarix would instead be financed (on the liabilities side) both by equity and debt (50% each). Explain verbally how that would change your expectations concerning the expected return and risk of its stock?

2. Try to find the options that may be hidden in the following real-life situations A and B and identify whether you are the owner or writer of a call (C) or put (P) option. Describe also, if information given, whether the option is in-the-money or out-of-the-money, and how the existence of the option affects what you are willing to pay for the instrument / your willingness to accept the deal as compared to a situation where there would not be an

option imbedded.

© A. You have one year ago borrowed money from a bank at a fixed interest rate of 6%. The remaining borrowing time is 9 years. The loan is paid back annually (in equally large amortizations) together with the annual interest payment. However, if you want, you can repay the loan sooner (amortize it faster) than in 10 years at no additional cost. The current long-term (« 9 y.) bond yield is 5.2%.

B. You are an owner of a convertible bond that can, within 2 years, be converted to 5 stocks in Nokia. The current market value of the bond is EUR 1000, and the price of one Nokia stock is EUR 21,70. ® C. Assume that you are the owner of a call option on the Nokia stock.

Assume further that Nokia has chosen one of the two alternative network standards for the future, and is the only one producing this one. Many believe that both networks could co-exist for a reasonable time period, and Nokia is assumed to get a 50% market share worldwide. Suppose that suddenly a group of central country leaders decide that the network question will be solved once and for ail, and only one standard will be accepted worldwide. Nokia's standard has a 50% chance of being selected as the chosen one. How would this affect the price of your Nokia call option?

The sudden emergence of new standard will increase the risks for Nokia which in turn decreases the price of nokia stocks which means that the call options will become more out of money so it will decrease the price of the call options.

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