Josephine has $1000 to invest today. She intends to invest the entire capital with the expectation of receiving returns. After inquiry and consideration, she narrows down the following options

a.A zeroissued by the Governmentwhich will give a face value of $1071.22 at the end of year 2

b.A junk bondwith an interest rate of 7%, with a 30% probability of return

c.A stock with beta 0.7, at a risk free rate of 2.0% and an expected market return of4.0%.

Josephine asks you for help tocompute returns of the various instruments.Show your calculations clearly.

Based on your knowledge at discussions at 3310A, which option wouldadvise Josephine to invest in if she wants to

d.Maximizeher returns?

e.Adopt a risk-averse stance? (6 marks)

RMULA SHEET

Bond Valuation

Value of a bond - Derive YTM / YTC / Value of a zero coupon bond

Determinants of market interest rates

rd= r* + IP + DRP + LP + MRP

Risk, Return and the CAPM

The Cost of Capital

WACC = wdrd(1 - T) + wpsrps+ wcers

The Basics of Capital Budgeting

Cash Flow Estimation