(d) Suppose that to fund this new project, you have borrowed a $120 million loan. You decide to repay $30 million at the end of the first year, $40 million in two years, and the rest in three years. The free cash flows of the new project are the same as in part

(c). Which valuation method is the most appropriate? What is the NPV of your project? (10 marks)

(e) Assume perfect capital markets. Golden has decided to delever the firm by issuing new  equity  and  completely  repaying  all  the  outstanding  debt.  Stephen,  as  a shareholder owning 1,500 shares of Golden stock, disagrees with the firm’s decision. Describe what  Stephen  could  do  to  undo  the  effect  of this  decision  (show your calculations). (8 marks) (Total: 30 marks)

Question 2

(a)SilverCorporationhasa$20millionloandueattheendoftheyear. Silver’stotal assets will have a market value of only $15 million when the loan comes due. Currently Silver has $2 million in cash. The company is considering two possible alternative uses for this cash. One possibility is to pay the $2 million out to shareholders in the form of a special dividend. The second possibility is to invest the $2 million into a project, which could offer an NPV of $4 million. Assume that Silver’s management acts in the best interests of its equity holders.

(i) What is the payoff to equity holders under each of the two alternatives? Which alternative would equity holders prefer?

(ii) What is the payoff to debt holders under each of the two alternatives? Which alternative would debt holders prefer?

(iii) Identify and discuss the agency issue that arises in this example. (10 marks)

(b) Copper Inc. is currently financed by equity only. The forecast of Copper’s net income for the coming year is shown below (in thousands of dollars):

EBIT                                                                $2,000

Interest expense                                                    0

Net income

$1,400

The corporate tax rate is 30%. Copper’s managers are expected to waste 10% of its net  income  on  needless  perks,  pet  projects,  and  other  expenditures that  do  not contributetothefirm. Allremainingincomewillbereturnedtoshareholdersthrough dividends and share repurchases. Copper is considering raising funds by issuing debt. If debt is issued, an interest expense of $400,000 needs to be incurred in the coming year.

(i) If Copper does not issue debt, how much will shareholders receive in the coming year in the form of dividends and share repurchases?

(ii) With the issue of new debt, what is the total amount Copper needs to pay to all investors (including both shareholders and debt holders) in the coming year?

(iii) Compare answers in (i) and (ii). Based on the result, discuss one benefit of debt financing. (10 marks)

(c) Discuss the signaling effect of the following given asymmetric information:

(i) the use of leverage. (ii) the issue of equity.

In your answers, discuss whether each action is generally viewed as a positive or negative signal and provide explanations. (8 marks) (Total: 28 marks)

Question 3

Zinc Company’s stock has a current price of $40 per share and a volatility of 30%. The stock pays no dividends. You are interested in valuing a one-year European put option on Zinc stock with a strike price of $45. Assume that the beta of Zinc stock is 0.9, and the risk-free interest rate is 4%.

(a) What is the value of this put option? (4 marks)

(b) What is the intrinsic value of the put option? What is the time value of the put option? Explain why this put option has a positive or negative time value. (4 marks)

(c)Assumethattheputpriceyougetfrompart(a)is$6.8. Youfindthatthecorresponding European call option on Zinc stock with a strike price of $45 is currently selling for $3. Describe what you could do to exploit this opportunity to make a profit. (6 marks)

(d) What is the leverage ratio of the put option? What is the beta of the put option? Based on your answers, discuss why investors may want to include put options in their portfolios. (4 marks)

(e) Describe the circumstance where it would be optimal to exercise an American put option prior to their expiration. (4 marks) (Total: 22 marks)

Question 4

(a) If you are an uninformed investor and decide to invest in every IPO available in the market, will you necessarily make money from the IPO underpricing? Explain. (6 marks)

(b) Iron Corporation pays a regular dividend of $1.6 per share. Typically, the stock price drops by $1.2 per share when the stock goes ex-dividend. Suppose the capital gains tax  rate  is   21%,  but  investors  pay  different  tax  rates  on  dividends.  Absent transactions  costs,  if  an  investor  would  like  to  gain  from  the  dividend  capture strategy, in what range does the dividend tax rate need to be? (6 marks)