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UGBA 103 Introduction to Finance

Review Section
Sheisha Kulkarni & Vijayant Bhatnagar
UC Berkeley Haas School of Business

Spring 2016

UGBA 103 Introduction to Finance

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Capital Structure

Payout Policy

Capital Budgeting and Valuation

Options

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Capital Structure

Capital Structure

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Capital Structure

Question 1
Consider a project with free cash flows in one year of $145,000 or
$195,000, with each outcome being equally likely. The initial
investment required for the project is $120,000 and the projects cost of
capital is 30%. The risk-free interest rate is 12%.
1. What is the NPV of this project?

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Capital Structure

Question 1
Consider a project with free cash flows in one year of $145,000 or
$195,000, with each outcome being equally likely. The initial
investment required for the project is $120,000 and the projects cost of
capital is 30%. The risk-free interest rate is 12%.
1. What is the NPV of this project?
E[CF1 ]
initial cash flow
1 + rc
0.5 145, 000 + 0.5 195, 000
=
120, 000
1.30
170, 000
=
120, 000 = 10, 769
1.3

NPV =

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Capital Structure

Question 1
Consider a project with free cash flows in one year of $145,000 or
$195,000, with each outcome being equally likely. The initial
investment required for the project is $120,000 and the projects cost of
capital is 30%. The risk-free interest rate is 12%.
2. Suppose that to raise the funds for the initial investment, the
project is sold to investors as an all-equity firm. The equity holders
will receive the cash flows of the project in one year. What is the
initial market value of the unlevered equity?

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Capital Structure

Question 1
Consider a project with free cash flows in one year of $145,000 or
$195,000, with each outcome being equally likely. The initial
investment required for the project is $120,000 and the projects cost of
capital is 30%. The risk-free interest rate is 12%.
2. Suppose that to raise the funds for the initial investment, the
project is sold to investors as an all-equity firm. The equity holders
will receive the cash flows of the project in one year. What is the
initial market value of the unlevered equity?
E[CF1 ]
1 + rc
0.5 145, 000 + 0.5 195, 000
=
1.30
170, 000
=
= 130, 769
1.3

Equity value =

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Capital Structure

Question 1
Consider a project with free cash flows in one year of $145,000 or
$195,000, with each outcome being equally likely. The initial
investment required for the project is $120,000 and the projects cost of
capital is 30%. The risk-free interest rate is 12%.
3. Suppose that initial $120,000 is instead raised by borrowing at the
risk-free rate. What are the cash flows of the levered equity, and
what is its initial value according to MM?

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Capital Structure

Question 1
Consider a project with free cash flows in one year of $145,000 or
$195,000, with each outcome being equally likely. The initial
investment required for the project is $120,000 and the projects cost of
capital is 30%. The risk-free interest rate is 12%.
3. Suppose that initial $120,000 is instead raised by borrowing at the
risk-free rate. What are the cash flows of the levered equity, and
what is its initial value according to MM?
I
I
I

equity value is total firm value minus debt value


value of debt next period is debt valuerf
equity cash flow is the difference between total cash flow and cash
to debt.

Debt
Equity
Total

Value at year 0
120,000
10,769
130,769

CF Strong
134,400
60,600
195,000

UGBA 103 Introduction to Finance

CF Weak
134,400
10,600
145,000
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Capital Structure

Question 2

Explain what is wrong with the following argument:


If a firm issues debt that is risk free, because there is no possibility of
default, the risk of the firms equity does not change. Therefore,
risk-free debt allows the firm to get the benefit of a low cost of capital
of debt without raising its cost of equity."

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Capital Structure

Question 2

Explain what is wrong with the following argument:


If a firm issues debt that is risk free, because there is no possibility of
default, the risk of the firms equity does not change. Therefore,
risk-free debt allows the firm to get the benefit of a low cost of capital
of debt without raising its cost of equity."
The argument is wrong because any leverage raises the equity cost of
capital. Risk-free leverage raises it the most because it does not share
any of the risk.

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Capital Structure

Question 3
In mid-2012, AOL Inc. had $200 million in risk-free debt, total equity
capitalization of $3.3 billion, and an equity beta of 0.92. Included in
AOLs assets was $1.6 billion in cash and risk-free securities. Assume
that the risk-free rate of interest is 2.9% and the market risk premium
is 4.1%.
1. What is AOLs enterprise value?

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Capital Structure

Question 3
In mid-2012, AOL Inc. had $200 million in risk-free debt, total equity
capitalization of $3.3 billion, and an equity beta of 0.92. Included in
AOLs assets was $1.6 billion in cash and risk-free securities. Assume
that the risk-free rate of interest is 2.9% and the market risk premium
is 4.1%.
1. What is AOLs enterprise value?
Enterprise value=Total equity+Debt-Cash
Enterprise value=3.3+0.2-1.6=1.9 billion.

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Capital Structure

Question 3
In mid-2012, AOL Inc. had $200 million in risk-free debt, total equity
capitalization of $3.3 billion, and an equity beta of 0.92. Included in
AOLs assets was $1.6 billion in cash and risk-free securities. Assume
that the risk-free rate of interest is 2.9% and the market risk premium
is 4.1%.
1. What is AOLs enterprise value?
Enterprise value=Total equity+Debt-Cash
Enterprise value=3.3+0.2-1.6=1.9 billion.
2. What is the beta of AOLs business assets?

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Capital Structure

Question 3
In mid-2012, AOL Inc. had $200 million in risk-free debt, total equity
capitalization of $3.3 billion, and an equity beta of 0.92. Included in
AOLs assets was $1.6 billion in cash and risk-free securities. Assume
that the risk-free rate of interest is 2.9% and the market risk premium
is 4.1%.
1. What is AOLs enterprise value?
Enterprise value=Total equity+Debt-Cash
Enterprise value=3.3+0.2-1.6=1.9 billion.
2. What is the beta of AOLs business assets?
D
E
E +
D
E +D
E +D
3.3
=
0.92 = 1.6
1.9

U =

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Capital Structure

Question 3
In mid-2012, AOL Inc. had $200 million in debt, total equity
capitalization of $3.3 billion, and an equity beta of 0.92. Included in
AOLs assets was $1.6 billion in cash and risk-free securities. Assume
that the risk-free rate of interest is 2.9% and the market risk premium
is 4.1%.
3. What is AOLs pre-tax WACC?

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Capital Structure

Question 3
In mid-2012, AOL Inc. had $200 million in debt, total equity
capitalization of $3.3 billion, and an equity beta of 0.92. Included in
AOLs assets was $1.6 billion in cash and risk-free securities. Assume
that the risk-free rate of interest is 2.9% and the market risk premium
is 4.1%.
3. What is AOLs pre-tax WACC?
rWACC = rf + U MRP
= 0.029 + 1.6 0.041 = 0.095
AOLs pre-tax WACC is 9.5%.

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Payout Policy

Payout Policy

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Payout Policy

Question 4
EJH Company has a market capitalization of $3.1 billion and 36 million
shares outstanding. It plans to distribute $125 million through an open
market repurchase. Assuming perfect capital markets:
1. What will the price per share of EJH be right before the
repurchase?

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Payout Policy

Question 4
EJH Company has a market capitalization of $3.1 billion and 36 million
shares outstanding. It plans to distribute $125 million through an open
market repurchase. Assuming perfect capital markets:
1. What will the price per share of EJH be right before the
repurchase?
Price per share=Equity value/shares
outstanding=3,100/36=$86.11
2. How many shares will be repurchased?

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Payout Policy

Question 4
EJH Company has a market capitalization of $3.1 billion and 36 million
shares outstanding. It plans to distribute $125 million through an open
market repurchase. Assuming perfect capital markets:
1. What will the price per share of EJH be right before the
repurchase?
Price per share=Equity value/shares
outstanding=3,100/36=$86.11
2. How many shares will be repurchased?
Number of shares=amount distributed/price per
share=125/86.11=1.45 million shares
3. What will the price per share of EJH be right after the repurchase?

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Payout Policy

Question 4
EJH Company has a market capitalization of $3.1 billion and 36 million
shares outstanding. It plans to distribute $125 million through an open
market repurchase. Assuming perfect capital markets:
1. What will the price per share of EJH be right before the
repurchase?
Price per share=Equity value/shares
outstanding=3,100/36=$86.11
2. How many shares will be repurchased?
Number of shares=amount distributed/price per
share=125/86.11=1.45 million shares
3. What will the price per share of EJH be right after the repurchase?
Price per share=equity value/shares
outstanding= 3,100125
361.45 =$86.11

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Payout Policy

Question 5
The HNH Corporation will pay a constant dividend of $3.50 per share,
per year, in perpetuity. Assume all investors pay a 22% tax on
dividends and that there is no capital gains tax. Suppose the other
investments with equivalent risk to HNH stock offer an after-tax return
of 9%.
1. What is the share price of HNH stock?

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Payout Policy

Question 5
The HNH Corporation will pay a constant dividend of $3.50 per share,
per year, in perpetuity. Assume all investors pay a 22% tax on
dividends and that there is no capital gains tax. Suppose the other
investments with equivalent risk to HNH stock offer an after-tax return
of 9%.
1. What is the share price of HNH stock?
CF = Div (1 d ) = 3.50 (1 0.22) = 2.73
2.73
P=
= 30.33
0.09
2. Assume that management makes a surprise announcement that
HNH will no longer pay dividends but will use the cash to
repurchase stock instead. What is the price of a share of HNH
stock now?
3.50
CF = 3.50, P =
= 38.89
0.09
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Capital Budgeting and Valuation

Capital Budgeting and Valuation

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Capital Budgeting and Valuation

Question 6
Suppose Goodyear Tire and Rubber Company is considering divesting
one of its manufacturing plants. The plant is expected to generate free
cash flows of $2 million per year, growing at a rate of 3% per year.
Goodyear has an equity cost of capital of 9%, a debt cost of capital of
7.5%, a marginal corporate tax rate of 40%, and a debt-equity ratio of
3.1. If the plant has average risk and Goodyear plans to maintain a
constant debt-equity ratio, what after-tax amount must it receive for the
plant for the divestiture to be profitable?

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Capital Budgeting and Valuation

Question 6
Suppose Goodyear Tire and Rubber Company is considering divesting
one of its manufacturing plants. The plant is expected to generate free
cash flows of $2 million per year, growing at a rate of 3% per year.
Goodyear has an equity cost of capital of 9%, a debt cost of capital of
7.5%, a marginal corporate tax rate of 40%, and a debt-equity ratio of
3.1. If the plant has average risk and Goodyear plans to maintain a
constant debt-equity ratio, what after-tax amount must it receive for the
plant for the divestiture to be profitable?
E
D
rE +
rD (1 C )
E +D
E +D
1
3.1
=
0.09 +
0.075 (1 0.4) = 0.056
1 + 3.1
1 + 3.1
CF
2
VL =
=
= 76.9 million
rWACC g
0.056 0.03

rWACC =

So the divestiture is profitable only if Goodyear receives more than


$76.9 million after tax.
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Capital Budgeting and Valuation

Question 7
Suppose Alcatel-Lucent has an equity cost of capital of 12%, market
capitalization of $12.06 billion, and an enterprise value of $18 billion
with a debt cost of capital of 8% and its marginal tax rate is 40%.
1. What is Alcatel-Lucents WACC?

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Capital Budgeting and Valuation

Question 7
Suppose Alcatel-Lucent has an equity cost of capital of 12%, market
capitalization of $12.06 billion, and an enterprise value of $18 billion
with a debt cost of capital of 8% and its marginal tax rate is 40%.
1. What is Alcatel-Lucents WACC?
E
D
rWACC =
rE +
rD (1 C )
E +D
E +D
12.06
18 12.06
=
0.12 +
0.08 (1 0.4) = 0.0962
18
18
2. If Alcatel-Lucent maintains a constant debt-equity ratio, what is the
value of a project with average risk and the following expected free
Year
0
1
2
3
cash flows?
FCF ($ million) -100 60 110 80

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Capital Budgeting and Valuation

Question 7
Suppose Alcatel-Lucent has an equity cost of capital of 12%, market
capitalization of $12.06 billion, and an enterprise value of $18 billion
with a debt cost of capital of 8% and its marginal tax rate is 40%.
1. What is Alcatel-Lucents WACC?
E
D
rWACC =
rE +
rD (1 C )
E +D
E +D
12.06
18 12.06
=
0.12 +
0.08 (1 0.4) = 0.0962
18
18
2. If Alcatel-Lucent maintains a constant debt-equity ratio, what is the
value of a project with average risk and the following expected free
Year
0
1
2
3
cash flows?
FCF ($ million) -100 60 110 80
VL =

60
110
80
+
+
= 207.01 million
2
1.0962 1.0962
1.09623
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Capital Budgeting and Valuation

Question 8
Acort Industries has 20 million shares outstanding and a current share
price of $30 per share. It also has a long-term debt outstanding. This
debt is risk free, is four years away from maturity, has an annual
coupon rate of 5%, and has a $125 million face value. The first of the
remaining coupon payments will be due in exactly one year. The
riskless interest rates for all maturities are constant at 3%. Acort has
EBIT of $115 million, which is expected to remain constant each year.
New capital expenditures are expected to equal depreciation and
equal $22 million per year, while no changes to net working capital are
expected in the future. The corporate tax rate is 38%, and Acort is
expected to keep its debt-equity ratio constant in the future (by either
issuing additional new debt or buying back some debt as time goes
on).
1. Based on this information, estimate Acorts WACC.
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Capital Budgeting and Valuation

Question 8
1. Based on this information, estimate Acorts WACC.
Calculate equity value:
E = 20 30 = 600 million
Calculate debt value:


1
1
FV
D = CPN
1
+
N
y
(1 + y )
(1 + y )N


1
6.25
125
1
=
+
4
0.03
(1.03)
1.034
= 134.29 million
So the enterprise value is E+D=600+134.29=734.29 million.

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Capital Budgeting and Valuation

Question 8
To calculate FCF, use
FCF = EBIT (1 C ) + Dep Capex NWC
= 115 (1 0.38) = 71.3 million
Since the firm is not expected to grow, the WACC can be computed
using the following formula:
VL =

FCF
FCF
71.3
rWACC =
=
= 0.0971
L
rWACC
734.29
V

2. What is Ascorts equity cost of capital?

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Capital Budgeting and Valuation

Question 8
To calculate FCF, use
FCF = EBIT (1 C ) + Dep Capex NWC
= 115 (1 0.38) = 71.3 million
Since the firm is not expected to grow, the WACC can be computed
using the following formula:
VL =

FCF
FCF
71.3
rWACC =
=
= 0.0971
L
rWACC
734.29
V

2. What is Ascorts equity cost of capital?


E
D
rE +
rD (1 C )
E +D
E +D
600
134.29
0.0971 =
rE +
0.03(1 0.38) rE = 0.1147
734.29
734.29
Ascorts equity cost of capital is 11.47%.
rWACC =

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Options

Options

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Options

Question 9
The current price of Estelle Corporation stock is $40.00. Next year, this
stock price will either go up by 10% or go down by 10%. The stock
pays no dividends. The one-year risk-free interest rate is 4.0% and will
remain constant. Using the Binomial Model, calculate the price of a
one-year call option on Estelle stock with a strike price of $40.00.

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Options

Question 9
The current price of Estelle Corporation stock is $40.00. Next year, this
stock price will either go up by 10% or go down by 10%. The stock
pays no dividends. The one-year risk-free interest rate is 4.0% and will
remain constant. Using the Binomial Model, calculate the price of a
one-year call option on Estelle stock with a strike price of $40.00.

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Options

Question 9
The current price of Estelle Corporation stock is $40.00. In each of the
next two years, this stock price will either go up by 10% or go down by
10%. The stock pays no dividends. The one-year risk-free interest rate
is 4.0% and will remain constant. Using the Binomial Model, calculate
the price of a one-year call option on Estelle stock with a strike price of
$40.00.
U D
44 36
=2
=
CU CD
40


1
D mCD
C=
S
m
1 + rf


36 2 0
1
=
40
= 2.69
2
1 + 0.04

m=

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Options

Question 10
Suppose a stock is currently trading for $65, and in one period will
either go up by 25% or fall by 15%. If the one-period risk-free rate is
4.0%, what is the price of a European put option that expires in one
period and has an exercise price of $65? Suppose the option actually
sold in the market for $8. Describe a trading strategy that yields
arbitrage profits.

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Options

Question 10
Suppose a stock is currently trading for $65, and in one period will
either go up by 25% or fall by 15%. If the one-period risk-free rate is
4.0%, what is the price of a European put option that expires in one
period and has an exercise price of $65? Suppose the option actually
sold in the market for $8. Describe a trading strategy that yields
arbitrage profits.

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Options

Question 10
Suppose a stock is currently trading for $65, and in one period will
either go up by 25% or fall by 15%. If the one-period risk-free rate is
4.0%, what is the price of a European put option that expires in one
period and has an exercise price of $65? Suppose the option actually
sold in the market for $8. Describe a trading strategy that yields
arbitrage profits.
U D
81.25 55.25
m=
=
= 2.67
CU CD
0 9.75


55.25 + 2.67 9.75
1
65
= 4.92
P=
2.67
1 + 0.04

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Options

Question 10
Suppose a stock is currently trading for $65, and in one period will
either go up by 25% or fall by 15%. If the one-period risk-free rate is
4.0%, what is the price of a European put option that expires in one
period and has an exercise price of $65? Suppose the option actually
sold in the market for $8. Describe a trading strategy that yields
arbitrage profits.
U D
81.25 55.25
m=
=
= 2.67
CU CD
0 9.75


55.25 + 2.67 9.75
1
65
= 4.92
P=
2.67
1 + 0.04
D mCD
1 + rf
1
D mCD
P= S
m
m(1 + rf )
P = 0.37S + 29.27

S mP =

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Options

Question 10

Suppose a stock is currently trading for $65, and in one period will
either go up by 25% or fall by 15%. If the one-period risk-free rate is
4.0%, what is the price of a European put option that expires in one
period and has an exercise price of $65? Suppose the option actually
sold in the market for $8. Describe a trading strategy that yields
arbitrage profits.
If the put is actually selling for $8, then it is overpriced. The arbitrage
trading opportunity will involve selling the put, 0.37 of a stock and
invest 29.27.

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Options

Question 11
Suppose the current price of Narver Network systems stock $55 per
share. In each of the next two years, the stock price will either increase
by 25% or decrease by 15%. The 6% one-year risk-free rate of interest
will remain constant. Suppose the put option with a strike price of $60
actually sold today for $3.87. You do not know what the option will
trade for next period. Describe a trading strategy that will yield
arbitrage profits.

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Options

Question 11
Suppose the current price of Narver Network systems stock $55 per
share. In each of the next two years, the stock price will either increase
by 25% or decrease by 15%. The 6% one-year risk-free rate of interest
will remain constant. Suppose the put option with a strike price of $60
actually sold today for $3.87. You do not know what the option will
trade for next period. Describe a trading strategy that will yield
arbitrage profits.

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Options

Question 11
Suppose the current price of Narver Network systems stock $55 per
share. In each of the next two years, the stock price will either increase
by 25% or decrease by 15%. The 6% one-year risk-free rate of interest
will remain constant. Suppose the put option with a strike price of $60
actually sold today for $3.87. You do not know what the option will
trade for next period. Describe a trading strategy that will yield
arbitrage profits.
Box 1:
85.94 58.44
= 17.63
0 1.56


1
58.44 + 17.63 1.56
P=
68.75 +
= 0.7
17.63
1 + 0.06

m=

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Options

Question 11
Suppose the current price of Narver Network systems stock $55 per
share. In each of the next two years, the stock price will either increase
by 25% or decrease by 15%. The 6% one-year risk-free rate of interest
will remain constant. Suppose the put option with a strike price of $60
actually sold today for $3.87. You do not know what the option will
trade for next period. Describe a trading strategy that will yield
arbitrage profits.
Box 2:
58.44 39.74
= 1
1.56
 20.26

1
39.74 + 1 20.26
P=
46.75 +
= 9.85
1
1 + 0.06

m=

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Options

Question 11
Suppose the current price of Narver Network systems stock $55 per
share. In each of the next two years, the stock price will either increase
by 25% or decrease by 15%. The 6% one-year risk-free rate of interest
will remain constant. Suppose the put option with a strike price of $60
actually sold today for $3.87. You do not know what the option will
trade for next period. Describe a trading strategy that will yield
arbitrage profits.
Box 3:
68.75 46.75
= 2.4
0.7 
9.85

1
46.75 + 2.4 9.85
P=
55
= 4.76
2.4
1 + 0.06

m=

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Options

Question 11
Suppose the current price of Narver Network systems stock $55 per
share. In each of the next two years, the stock price will either increase
by 25% or decrease by 15%. The 6% one-year risk-free rate of interest
will remain constant. Suppose the put option with a strike price of $60
actually sold today for $3.87. You do not know what the option will
trade for next period. Describe a trading strategy that will yield
arbitrage profits.
Box 3:
68.75 46.75
= 2.4
0.7 
9.85

1
46.75 + 2.4 9.85
P=
55
= 4.76
2.4
1 + 0.06

m=

If the put is selling for $3.87 it is underpriced. You should purchase the
put and the stock, and borrow $27.67 at the risk-free rate.
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