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Consider an oil-wildcatting problem. A decision maker has mineral rights on a piece of land that he believes may have oil underground. There is a 30% chance that the decision maker will strike oil if he drills. If he drills and strikes oil, then the net payoff is $180,000. If he drills and does not strike oil, then there will be a $10,000 loss due to the sunk cost. The alternative is not to drill at all, in which case the decision maker's net payoff is $0.
Before the decision maker drill he might consult a geologist who can assess the promise of the piece of land. The geologist can tell the decision maker whether the decision maker's prospects are "good" or "poor". But she (the geologist) is not a perfect predictor. If there is oil, the conditional probability is 0.9 that she will say good. If there is no oil, the conditional probability is 0.85 that she will say poor.
What is the maximum amount that the decision maker (assume he is rational) is willing to pay the geologist for her information? (Calculate EVSI.)
Suppose you create a portfolio by holding 100 shares of McDonald’s stock, writing a call option on the stock with an exercise price of 55 and one year to expiration and writing a put option on the same stock with an exercise price of 25 and one year ..
What is the current account generally composed of? What is the financial account generally composed of? What are some of the major objectives of the IMF?
You have just bought a 5 year 10% annual coupon bond with a par value of $1000 at a price of $963.04. Immediately after you bought the bond, the market interest rate changed to 8% per year. If the interest rate does not change from this level for the..
If you receive $2,590 at the end of each year for the first three years and $627 at the end of each year for the next two years. What is the future value of this cash flow stream? Assume interest rate is 6%.
Digital Organics (DO) has the opportunity to invest $0.90 million now (t = 0) and expects after-tax returns of $500,000 in t = 1 and $600,000 in t = 2. The project will last for two years only. The appropriate cost of capital is 12% with all-equity f..
You are evaluating a proposal to buy a new machine. The base price is $108,000, and shipping and installation costs would add another $12,500. The machine is depreciated using prime cost method (3 years useful life), and it would be sold after 3 year..
Jeff believes that Microsoft stock will move significantly in either direction with the release of the next version of Windows. Jeff wants to design a strangle strategy to take advantage of the possible move in the stock price. Should Jeff embark on ..
Two bonds have a coupon rate of 6.5 percent, semi-annual payments, face values of $1,000, and yields to maturity of 7.1 percent. Bond S matures in 6 years and bond L matures in 12 years. What is the difference in the current prices of these bonds?
You own all the equity of ABC Co. The company currently has no debt. The company’s annual cash flow is $700,000 before interest and taxes. The corporate tax rate is 35%. You have the option to exchange 1/3of your equity position for 4% coupon bonds w..
LOAN AMORTIZATION AND EAR You want to buy a car, and a local bank will lend you $20,000. The loan will be fully amortized over 5 years (60 months), and the nominal interest rate will be 12% with interest paid monthly. What will be the monthly loan pa..
A two-year STRIPS sells at an interest rate of 3.84 percent and a three-year STRIPS sells at a rate of 3.97 percent. What is the implied one year interest rate two years from now? Assume the rates are effective annual rates. A $50,000 face value STRI..
Currently, one share of ABC stock is valued at 92. You are given the following prices of European options on one share of this stock: You buy one 95-strike call option. On the expiration date of the option, ABC stock has a price of 101 per share. Fin..
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