QUESTION 2 [15 Marks]

The market value of the assets of a corporation is currently $195.0 million and the firm has on issue a debt outstanding that has a par value of $145.0 million and a due date of exactly five years. No intermediate interest payments are required. The risk-free (continuous) rate is 1.25%.

Management is interested in the standard deviation of returns of the firm's assets so that they can negotiate with the debt holders a fair interest rate of approximately 9%.

What is the variance of returns of the firm's assets to achieve a fair interest rate of approximately 9% (your answer should ensure that the fair interest rate is in the range of >8% and )?

State any simplifying assumptions made in your calculations.