Question 1:
A treasurer argues with the CFO that because "interest rates have dropped substantially in the last year, the firm should best' back their current debt and issue new one to save on interest costs". The CFO answers that this only makes sense for "the bonds with call provisions." Which one is right? Why?
Question 2:
a) Give two reasons (referring to issues discussed in class) why issuing short-tem debt can create shareholder value vis-a-vis long-term debt.
b) Firms can issue debt publicly (e.g., in the form of publicly held bonds-say tradable bonds held by many small investors) or privately (e.g., in the form of non-tradable bonds held by institutions-say insurance companies, banks etc.). Give one reason why issuing publicly held debt can generate value for the firm and one reason why issuing privately held debt can generate firm value. (Please assume that in either case the debt is fairly priced, i.e., investors are getting a fair expected Term on their investments.)
Question 3:
A treasurer makes the following proposal to a CFO: "We can issue $100 million of debt and use the proceeds to buy back 50% of our shares. As a result, this would increase the DIE ratio of our firm and increase the expected return that the equity-holders that decide to stay with the firm." The CFO disagrees and replies that "no increase in expected return will occur, since, to entice some shareholders to sell their shares a .sufficient compensation needs to be offered to them". Which one is right? Why? (Please ignore taxes and any effect of debt on the firm's cash flows including bankruptcy and other financial distress costs.)
Question 4:
A treasurer is considering issuing common stock. He argues that "since the stock price has gone up by 20% during the last year now it is a good time to issue since shareholder dilution is higher after a rim-up in prices". Do you agree?
Question 5:
A hedge fund manager makes the following statement: "Since many put options have negative expected returns, writing puts that have negative expected returns is a profitable investment. That is, if we ifrite such put options, we will make money on average and enjoy abnormal expected returns."
a) Is it reasonable to state that "many put options have negative returns"?
b) Assuming that this is the case, explain whether the strategy proposed by the hedge fiend manager is profitable on average and whether or not it produces abnormal expected returns (i.e., returns above the fair compensation for the risk incurred by undertaking the strategy).
Question 6:
Can an increase in analyst coverage (i.e.. having more independent analysts following the stock) reduce a firm's cost of equity capital? Either in the affirmative or in the negative. please explain clearly your answer.
Question 7:
Evaluate the following statement from a CFO as true/false/uncertain: "Our P/E ratio is lower than all other comparable firms. This means that our stock is undervalued by the market and we should not sell stock since we are not getting a fair price for our equity." (Ignore possible leverage effects on P/E ratios in answering this question).
Question 8:
An investment banker estimates that if a firm issues 5500 million in equity the flnifs stock price would fall by 3% and that if the fum issues a convertible for the same amount the stock price would fall by 1.5%. Consequently. the investment banker recommends the firm to issue a convertible so that firm value for the current shareholders is preserved. Do you agree with the investment banker's recommendation?
PART TWO
Exercise 1:
The expected return of the S&P 500 (which you can assume is the tangency portfolio) is 16% mid has a Standard Deviation of 25% per year. Microsoft has a Standard Deviation of 20% per year and a covariance with the S&P500 of 0.1. If the risk-free is 6% per year and CAPM holds:
a) Calculate the expected return of Microsoft.
b) If Intel has half of the expected return of Microsoft then, what is Intel's beta?
c) Calculate the beta and expected return of a portfolio that invests in the following five assets in the following proportions: 25% in Microsoft; 10% in Intel; 75% in the S&P 500; -20% in GM (where I3GM =0.8) and 10% in the risk-free asset.
Exercise 2:
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 the operating expenses $48/barrel. Suppose that the forward price of oil delivered one year from now is $100/barrel and that no forward market is available in two years. Suppose that the risk free rate is 5%, that the beta of oil-well 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 $907barrel 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.
Exercise 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 computer. Demand is uncertain at year t=0. Demand at t=1 will be either high (probability 70%) or low (probability 30%). At year 1. Finn X will learn whether the demand for the computer is indeed high or low. To continue the project. Finn X must decide whether to spend an additional $3.6 million at year t=1. If X decides to continue the project. the computer 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.
Exercise 4:
Hermes Inc.. a producer of luxury goods. needs to spend 540.000 at year 0 to develop a new product. The demand for product is uncertain at year 0. At year 1. however. Hermes will learn whether the demand for the product is high (probability 5/11) or low (probability 6/11). To continue operations. and after learning the demand. Hermes must decide whether to spend an additional $20,000 at year I. If Hermes decides to continue operations. the product will generate at year 2 a CF of S110,000 if demand is high and of 550.000 if demand is low. There are no taxes, investors are risk-neutral and that the risk-free rate of zero. Assume that Hermes can only raise finance at t 1 by issuing new equity.
a) Assume that Hermes intends to finance the original 540.000 of year 0 by issuing senior debt that matures in year 2. Will Hermes be able to do so? If it can. calculate the face value of the senior debt, and the value of equity at t = 0 (right after raising the 540.000 in senior debt).
b) Assume that in the case of low demand. debt-holders could get together and renegotiate the face value of the debt. By how much should they reduce the face value of debt?
c) If debt-holders anticipate that they can renegotiate the face value of debt in the case of low demand: (i) Calculate the face value of the debt that Hermes must issue at W.) in order to raise $40,000: (ii) Calculate the value of equity at t = 0 (right after raising the 540.000 in senior debt). Very briefly explain why the value of equity is lower or higher than in part (a)?
d) Now assume that jn the case of high demand, if Hennes spends the additional 520,000 at year 1. the shareholders can take one of two alternative projects:
- A safe project, that as before, yields a CF of $110.000 at t =2.
- A risky project that yields a CF of 5140,000 or SO at t = 2 with equal probability (i.e., 0.5)
Hermes plans to finance as much as possible of the initial investment by issuing senior debt and the rest by issuing equity. Up to how much of the initial 540.000 can Hennes finance with senior debt? (Note: In part (d) assume that in the case of low demand renegotiation does NOT take place).
Question 5:
A firm would like to finance an investment project. The project yields a cash flow of $30 with probability p (in the "up" state) and $10 with probability (1-p) (in the "down" state). The project costs 411 and the firm's only asset is the ideas for this project. Thus, the $11 must be raised from external capital markets. Investors are risk-neutral and the risk-free interest rate is 0. Ignore taxes.
In other words, the situation can represent as follows:
T=0/-11 t=1
Either Up state (With probability p) $30
Or down state (With probability 1-p) $10
There is asymmetric information in the sense that the firm can be an overvalued firm (i.e., a "low" firm), in which case p = 0.5, or it can be an undervalued firm (i.e., a "high" type firm) in which case p = 0.7. The firm's manager knows the firm's type (i.e., the true p), but the capital markets do not. Before observing any financing announcement, the market believes the firm has a 50% chance of being undervalued and a 50% chance of being overvalued.
a. Suppose that the only financing vehicles are debt or equity, and suppose that the financial distress costs of debt are $2 (i.e. in case that the firm defaults the firm cash flows will be reduced by $2).
Suppose that the only financing vehicles are debt or equity, and suppose that the financing distress costs of debt are $2 (i.e. this explanation needs to be supported numerically.)
b. Describe (i.e. calculate) the stock market reaction after a firm decides to issues equity or debt. Explain.
c. Suppose now that the financing vehicles available to these firms are equity and convertible bonds with face value $11 (Straight debt is now impossible to issues). In addition, assume that financial distress costs are $5 (rather than $2 as in part a)).
Suppose that the market prices debt issuance as stemming from a "high type" firm and equity issuances as stemming from a "low" type firm. Find out which security each type of firm will issues and explain why (i.e. this explanation needs to be supported numerically.)
Note 1: After the cash flows are realized, the convertible bondholder will have a chance to covert. If they do so, the firm does not incur any financial distress costs. (This means that the convertibles are not callable but that the bondholders may voluntarily decide to convert.)
Note 2: The rest of terms of the convertibles bonds must be derived by you to be sure that the investor gets a fair compensations for investing in the issuing firm.)
d. Describe (i.e. calculate) the stock market reaction after a firm decides to issues equity or debt. Explain.