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BUSI4412-E1
BUSI4412-E1 Turn Over
The University of Nottingham
BUSINESS SCHOOL
LEVEL 4 MODULE, SUMMER SEMESTER EXAM 2021
FINANCIAL SECURITY VALUATION
Time allowed FORTY EIGHT Hours Expected time TWO Hours
INSTRUCTIONS:
ANSWER ALL QUESTIONS
Please provide all computations of your work.
Save and submit your work as a PDF or Word document, using the
following file naming convention: Student ID_Module code and title.
List your student ID, exam/module code and title, degree programme
and current academic year (2021) at the start of your exam script. Do
not include your name, so that your work can be marked anonymously.
Your answers should be typed, using font Verdana 11 point.
You can include hand-drawn diagrams and hand-written mathematical
notes in your exam answers (e.g. take a picture and integrate this into
the exam script). Do not include pictures of diagrams and mathematical
notes from other sources (e.g. lecture slides, books, journal articles).
Some exam papers include guidance on the expected answer length.
Take note and remember to address each question.
Label each answer, so that it is clear which question your answer refers
to.
ADDITIONAL MATERIAL: Included at the end of the exam
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There are two questions. Each question carries 50 points.
1. This question has three parts:
i. You would like to estimate the cost of capital for a new airline
business. Based on its industry asset beta, you have already
estimated an unlevered cost of capital for the firm of 9%. However,
the new business will be 25% debt financed, and you anticipate its
debt cost of capital will be 6%. If its corporate tax rate is 40%, what
is your estimate of its cost of capital (20 points)
ii. The current price of Pineapple stock is $50. In each of the next two
years, this stock price can either go up by $19 or go down by $11.
The stock pays no dividends. The one-year risk-free interest rate is
4% and will remain constant.
a) Using the Binomial Model, calculate the price of a two-year put option
on Pineapple stock with a strike price of $49. (8 points)
b) Using the Binomial Model, calculate the price of a two-year call option
on Pineapple stock with a strike price of $51. (7 points)
iii. Assume first that the interest rate for all horizons is 5%.
a) What is the price of a 5-year coupon bond that pays $200 for 4 years
and $1,600 in the fifth year What is its duration What is the
modified duration of this bond (3 points)
b) Let us assume that the interest rate changes by 25 basis point from
5% to 5.25%, what is the convexity and how the presence of
convexity affects the resulting change in its price (3 points)
c) Let us assume that the interest rate changes by 100 basis points from
5% to 6%, how the presence of convexity affects the resulting change
in its price Compare it with part iii and explain the results. (4 points)
d) As CFO of a leading bank, how do interest rate change affect your
balance sheet Hint: think of your balance sheet and debt interest
payments on varying maturities of debt. (5 points)
2. This question has three parts:
i. Pineapple stock has a volatility of 30% and a current stock price of
$50 per share. Pineapple pays no dividends. The risk-free interest is
4%.
a) Determine the Black-Scholes value of a one-year, at-the-money call
option on Pineapple stock. (5 points)
b) What is the impact on the value of this call option when the volatility
of the stock goes up by 5% to 35%. Explain your result. (5 points)
c) What is the impact on the value of this call option when the interest
rates go up by 1% to 5%. Explain your result. (5 points)
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d) What is the impact on the value of this call option when three months
elapse, with no other change. Explain your result. (5 points)
ii. Jonnie Depp Productions (JDP), suspended its dividend at the start
of 2009 and as of the middle of 2012, has not reinstated its
dividend. Suppose you do not expect JDP to resume paying
dividends until July 2014. You expect JDP’s dividend in July 2014 to
be $1.20 (paid annually), and you expect it to grow by 6% per year
thereafter. If JDP’s equity cost of capital is 10%, what is the value
of a share of JDP in July 2012 Explain your result. (15 points)
iii. A 6% five-year bond yields 15% and a 10% five-year bond yields
10%. Calculate the fifth-year spot rate. Assume annual coupon
payments. Explain your result. (15 points)
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Formula Sheet for Financial Securities Valuation
Black-Scholes European stock options
= ( ) [1 ( )] [1 ( )]
= ( ) ( ) ( )
=

( )

√
+

√

and = √
Put-Call parity: P = PV (K) + C – S
Binomial Options
=

; =

Bonds
Duration = D =
∑

.
(
)

.
( )

Modified Duration =
=

Convexity = CX =
∑

.( )
( )

.( )
( )

≈

. +
1
2
. ( )

Annuity and Perpetuity
PV of a growing perpetuity:

PV of a growing annuity:
1 ( )
( )

Dividend Discount Model
For dividends: =

; For earnings: =

Post-money Valuation = Pre-money Valuation + Amount Invested
CAPM:
( ) = + ( ( ) ), where ( ) is the market portfolio return.
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Cumulative Normal Distribution table N(x) for x 0
Notes: Interpolation for when a≤x