Q1
The term structure of interest rates is a static function that relates the term to maturity to the yield to maturity for a sample of bonds at a given point in time. Four types of yield curves are shown above.1 Three main theories that attempt to explain these different shapes are: 1. the expectations hypothesis; 2. the liquidity preference hypothesis; and 3. the segmented market hypothesis. Explain what each hypothesis is and critically evaluate how each hypothesis would explain or interpret each of the four shapes. Link your discussion to market (in)efficiency arguments. Your discussion would benefit from the inclusion of current market conditions as well as appropriate academic references.
Q 2
Suppose that the free cash flows available for a firm is £10 million at the moment. Furthermore, they are expected to grow at a rate of 10% over the next three years. Starting from year 4, the growth rate is expected to go down to 5% and remain at that level indefinitely. The firm’s cost of equity and cost of debt are 8% and 6%, respectively. Furthermore, the firm’s equity value is £360 million and there are 10 million shares outstanding. The market value of the firm’s debt is £90 million. The corporate tax rate is 40%.
Using the data provided above, comment on the intrinsic value of this firm.
You have been told that the cost of equity for the company above is estimated using the capital asset pricing model. Offer a critical discussion of this model.
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