May 2011,SFM Solution

Reply from prof NK Jain:

I differ on solution given in the attachment for question 1(a) & (b). According to me answer should be :

Answer 1 (a)

Return of the share E (R) as under

E (R_f ) = R_f +B₁F₁+B₂F₂+……..+B_nF_n

Where B₁ is firm j’s factor -1 Beta

F₁ is surprise in factor-1 and so on……….

E (R_f ) = 9.25+1.2(7.70-7.70) +1.75(7-5.50)+1.3(9-0.75)+1.70(12-10)+1(7.50-7)

E (R_f ) =9.25+0+2.625+1.624+3.4+0.50

E (R_f ) = 17.40%

Answer 1 (b)

Expected share price at 32 month

E(s_t) = 500 p + 400 (1- p)

As per risk –neutral method,

E (s_t) = Future value of S_o= 420

So, 500 p + 400 (1- p) = 420 X e^0.02

or, 500 p + 400 - 400p = 420 X 1.0202 = 428.484

or, 100 p = 28.484

or, p = 0.285

1- p = 0.715

Expected Vc = 50 X 0.285 + 0 X 0.715 = 14.25

Co= pv of call = 14.25 X e -0.08X3/12

= 14.25/1.0202

=13.97