QUESTION 5 (30 marks) a) A company considers investing in one of two mutually exclusive projects. The nominal cash flows associated with the projects are described in the table below: Project/Period A B Year 0 Year 1 Year 2 50 50 60 70 -50 -90 Project A has risk that is comparable to that of the company's current assets. Project B has risk that is different to the risks associated with the company's cash-flows. Project B's cash-flow is however uncorrelated with the market returns. The current risk-free interest rate is 4%, and the expected market risk premium is 9%. The company has a debt/equity ratio of 0.3, and the beta for the company's stock is 1.4 while the beta for its debt is 0.35. Which project should the company invest in? (8 marks) b) Below are the probabilities for the economy's five possible states next year, with the corresponding returns on the market and on ABC Inc stock. Economic Condition Probability Market Return ABC Return Moderate expansion 0.40 0.18 0.09 No growth 0.45 0.14 0.06 Contraction 0.15 0.02 -0.03 i) What is the expected return and variance on the market and ABC? ii) What is the beta of ABC stock returns? (6 marks) (9 marks) c) Suppose the expected inflation growth influences your firm's net earnings. Furthermore, the expected inflation growth is positively serially correlated (that is, a positive correlation between the level of the variable and its value during the previous period). Assume that the market is efficient. Would you expect price changes in your stock to be serially correlated? Why or why not?