Reference no: EM133294652

Question 1 A treasurer argues with the CFO that because "interest rates have dropped substantially in the last year, the firm should buy back their current debt and issue new one to save on interest costs". The CFO answers that this only makes sense for "bonds with call provisions." Which one is right? Why?

Question 2
Please use the CAPM logic to choose which if any of the following statements is (are) true. Explain.
a) The cost of equity is higher than the cost of debt for all firms.
b) The cost of equity is higher than the cost of debt only for firms whose debt is risk-free.
c) The cost of equity is higher than the cost of debt only if the firm's beta is positive.
d) The cost of equity is higher than the cost of debt only if the firm's beta is positive and when its debt is risk free.

Question 3
Consider the following financial position of the following three investors:
• Investor A holds one European call option with $20 exercise price on a portfolio that consists of one share of IBM and
one share of Microsoft.
• Investor B holds two European call options: one gives the right to the investor to buy a share of IBM for $10 and the
other option gives the right to buy a share of Microsoft for $10.
• Investor C also holds two European call options: one gives the right to the investor to buy a share of IBM for $15 and
the other option gives the right to buy a share of Microsoft for $5.
Which of the three investors has a more and a less valuable financial position? (If you need more information to determine
which position is more value please state so.) Explain.
(Assume that all the options considered in this question expire in exactly one year.)

Question 4
Two individuals X and Y approach a bank to request a $50,000 loan for a potential business. Assume that their business plans
are identical but that individual X owns $20,000 of his own wealth and is willing to invest it in the business while individual
Y is penniless.
(i) Give two reasons of why it is possible to have the following situation:
*A (competive) bank finds it equally profitable to lend $30,000 to X at rd= 8% that to lend $50,000 to Y at rd= 10%.
(ii) Explain why it possible to have the following situation:
*A (competitive) bank refuses to lend $50,000 to Y at any rate but agrees to lend to X $30,000 at rd= 8% instead.
To receive full credit you need to relate (i) and (ii) to specific concepts discussed in class. You may want to (but do not
need to) refer to examples in class/book or to build your own examples.

Question 5
A firm has $1 million of debt on its books. The debt does not contain any covenants restricting the issuance of additional debt
with equal seniority (i.e., pari-passu). The CFO wants to take advantage of this. Specifically, he plans to issue additional equalseniority
debt with face value of $1 million, and keep the proceeds as cash in the firm's bank account. Due to default risk, the
debt issue will be issued at a discount and will only allow the firm to raise $800,000. The CFO argues that this transaction will
benefit equity holders at the expense of existing debt holders. The CEO disagrees. In his words: "I cannot see the benefit to
equity holders of raising $800,000 and parking the cash in a bank account. In fact, we are making equity holders worse off
since they have to pay for the default premium of the new debt without receiving anything back in return."
Who is right, the CFO or the CEO? (Assume that the discount rate is zero and ignore taxes). Please explain.

Question 6
Evaluate the following statement from a CFO as true/false/uncertain:
"Since our business has no systematic risk (i.e., the asset beta of our firm is zero), our optimal leverage ratio is high.
Furthermore, we can use high levels of leverage while receiving relatively high ratings from the rating agencies".

Question 7 True/false/uncertain (a full, concise explanation will receive full credit).
(i) All else equal, an increase in the risk free rate reduces a bond price but can increase the forward price of that bond.
(ii) All else equal, an increase in the risk free rate reduces the price of stock X and increases the call option on stock X.
Question 8 (10 points) Empirically it is observed that firms with higher growth opportunities have a lower ratio of debt
over total assets in their balance sheets. Give three reasons related to arguments discussed in class that are consistent
with this empirical observation.

Second Part: Problems.
(We will take the three highest grades of your answers to these four problems.)

Question 1
An oil well will produce 100,000 barrels of oil next year and 250,000 barrels in two years (assume for simplicity that the oil will be available at the end of the year). After that, the oil well will be closed forever. Suppose that: (i) the operating expenses a r e $48/barrel, (ii) the forward price of oil delivered one year from now is $100/barrel and (iii) no forward market is available in two years. Suppose that the risk free rate is 5%, that the project beta of oil-wells is 0.9, and that the market expected risk premium is 6%. Suppose that, in the second year, the oil price fluctuates so it can be: $130/barrel, $100/barrel, or $90/barrel with equal probabilities.
a) Find the value of the oil well.
b) Suppose that the oil well would be only operative for one year (i.e., ignore any information about year two). Form a perfect tracking portfolio for the oil well and value the oil well in such a case.
c) Suppose that the oil well is only operative for one year (again, please ignore any information about year two) and that the one-year oil forward price is $40/barrel. What is the value of the oil well? Explain.
d) Suppose that in the second year the operating expenses are not a constant $48/barrel but they are $48/barrel on average and exhibit some variability. In particular, they are higher when the oil price is higher and lower when the oil price is lower. Is the value of the oil well higher, lower or equal than the value obtained in a)?
Explain. (Hint: You do not need to make calculations but refer to concepts discussed in class to answer this part of the question.)

Question 2
A vacant lot is zoned for construction of a condo building. The lot is suitable for a building with either 6 or 9 condo units. We want to value the lot from the perspective of a real estate developer, who considers when to build (this year or next year) and what to build (with 6 units or 9 units). Assume that:
• The risk free rate is 10%
• Per unit construction costs (this year or next year):
$100,000 for building with six units
$120,000 for building with nine units
• Construction does not take time (i.e., the real estate developer can immediately sell the condos in the year in
which he builds)
• Current price of each condo unit is $170,000
• Per year rental rate of a condo is $18,000 per unit (net of expenses, to be paid at the end of the year)
• Next year, if market conditions are:
Favorable, condos sell for $200,000
Unfavorable, condos sell for $140,000
a) Suppose that the real estate developer must build this year. What is the value of the lot?
b) Suppose that the real estate developer can wait and make the construction decision next year, after learning whether market conditions are favorable or unfavorable. What is the value of the lot?
c) Suppose now that there is a city council resolution that prohibits occupation of condos on this particular lot until next year. Specifically, the real estate developer can build condos (with 6 or 9 units) this year and sell them this year if he wishes to, but the buyers of the condos cannot live in them or rent them out until next year. The occupancy restriction will be lifted next year. As in part b, the developer can also wait until next year to make the construction decision. What is the value of the lot?

(Important: The current condo price given in the question is for condos that are not subject to an occupancy restriction. The occupancy restriction only applies to this particular lot.)

d) Ignore the previous city council resolution but suppose now that there is another city council resolution that prohibits building more than 6 condos now or in the future. In addition, suppose that the builder can build any number of condos (up to 6) at a cost (now or in a year) of $100,000 per condo. Find the value of the lot and describe the optimal use of the land by the builder. Explain.

Question 3
Make the usual assumptions of risk neutrality, a zero risk-free rate, and no taxes.
Firm X needs to spend $3.2 million at year 0 to develop a new product. Demand is uncertain at year t=0.
Demand at t=1 will be either high (probability 70%) or low (probability 30%). At year 1, Firm X will learn
whether the demand for the product is indeed high or low. To continue the project, Firm X must decide whether to
spend an additional $3.6 million at year t=1. If X decides to continue it, the project will produce at year t=2 a cash
flow of $18 million if demand is high, and of $4.8 million if demand is low. If X does not make the investment
at year 1, there will be no cash flows at year 2.

a) Assume that X intends to finance the original investment ($3.2 million) with senior debt held by a diffuse group of bondholders. Will X be able to finance the project? If so, find the face value of the debt that X must issue at year 0 to obtain the $3.2 million, and the value of the project for X.

b) Suppose that instead of two possible scenarios (i.e., high and low demand) demand can be high, medium or low with the following probabilities and cash flows. Demand Probability Cash Flow in year 2
High 20% $18 million
Medium 50% $7.5 million
Low 30% $4.8 million
Will Firm X be able to issue the bond to raise $3.2 million? If it can, find the face value of the bond. If it cannot, justify your answer with calculations.