Question: 3. (a) The following information describes the expected return and risk relationship for two stocks. Expected Return Standard Deviation Beta Stock X 15.0% 22 1.50

3. (a) The following information describes the expected return and risk relationship for two stocks. Expected Return Standard Deviation Beta Stock X 15.0% 22 1.50 Stock Y 8.0% 15 0.90 Market Index 10.0% 12 Risk-free rate 4.0% 1.00 Using only the data shown in the preceding table (i) Calculate the alpha for Stock X? (ii) Calculate the alpha for Stock Y? (iii) State whether the two stocks are undervalued or overvalued? (iv) Assume that the risk-free rate increase to 7 percent and with the other data in the preceding matrix remaining unchanged calculate the alpha for Stock X? (v) Is stock X undervalued or overvalued? (2+2+2+2+2=10 marks) (b) How to replicate the payoff of a bond (riskless portfolio) using shares and call options? Based on this conclusion, how does a single-step binomial tree option pricing model work? Use an example to demonstrate your answers. (Max.200 words, 10 marks) (c) List five steps to calculate the stock value using free cash flow to the firm (FCFF). Using your own words, explain the meaning of FCFF. (Max 100 words, 5 marks)

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