FIN307 Coursework
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FIN307 Coursework
Due date: 11:59pm, 3 December 2023
This assignment consists of five problem-solving and short-answer questions. Please complete all five questions and submit a soft copy by the due date above through the submission link on Learning Mall. Note: For problem-solving questions, please show all steps in detail. For short-answer questions, please provide answers in your own words. Marks will NOT be given for answers directly copy-pasted from textbooks, lecture notes, tutorial solutions or other learning materials.
Total: 100 marks
Question 1
For each of the four statements below, identify whether the statement made is corrector not. Provide justifications for your answers.
(a) It is known that Firm A’s cost of debt is lower than its cost of equity. Therefore, in a perfect capital market, FirmA can minimize its cost of capital by borrowing as much debt as it can.
(b) Under the CAPM assumptions, if you are an individual investor, the best investment strategy is trying to exploit positive alphas via active trading.
(c) Firm X operates a business in the airline industry, and Firm Y is a biotechnology firm. Based on the trade-off theory, Firm Y is more likely to have low optimal levels of debt.
(d) It is never optimal to exercise an American call option early.
(Total: 20 marks)
Question 2
Golden Corporation has a debt-equity ratio of 1.5. The current debt cost of capital is 5.5% and the equity cost of capital is 11%. Suppose that Golden now plans to repay some of its debt and reduce its debt-equity ratio to 1. If so, its debt cost of capital will be lowered to 5%.
For parts (a) and (b) below, assume perfect capital markets.
(a) What is Golden’sunlevered cost of capital? (4 marks)
(b) What is Golden’s equity cost of capital after the leverage level is reduced? (4 marks)
(c) Now assume that the corporate tax rate is 25% and Golden will maintain its debt- equity ratio of 1 in the future. Golden is considering investing in a new project. The expected free cash flows of the project areas follows:
|
Year |
0 |
1 |
2 |
3 |
|
Free cash flows (in $ million) |
(200) |
80 |
60 |
120 |
Calculate the NPV of this project using the WACC method. What are the key assumptions made when implementing this method? (8 marks)
(d) Suppose that to fund this new project, Golden has borrowed a $180 million loan with the principal to be paid in three equal installments at the end of each year. The free cash flows of the new project are the same as in part (c). The debt cost of capital is 5% and the corporate tax rate is 25%. Which valuation method is the most appropriate and why? What is the NPV of this project? (12 marks)
(Total: 28 marks)
Question 3
(a) Silver Corporation is evaluating the following three investment strategies. The probabilities of outcomes and the corresponding payoffs for each strategy are shown in the table below.
|
Strategy |
Probability |
Payoff (in $ millions) |
|
A |
100% |
100 |
|
B |
50% 50% |
170 0 |
|
C |
10% 90% |
320 50 |
Assume that Silver’s management acts in the best interests of its equity holders. Answer the following questions. Show calculations if necessary.
(i) Which strategy is optimal for Silver Corporation?
(ii) Which strategy will Silver choose if it has debt outstanding of $50 million? (iii) Which strategy will Silver choose if it has debt outstanding of $140 million?
(iv) Identify the relevant agency issue in this example and explain why it arises. (12 marks)
(b) Both equity and debt holdings can be viewed as an option or a portfolio containing options. Based on these views, explain the agency issue in part (a). (5 marks)
(Total: 17 marks)
Question 4
Zinc Company’s stock has a current price of $36 per share and a volatility of 25%. The stock pays no dividends. You are interested in valuing a one-year European call option on Zinc stock with a strike price of $33. Assume that the beta of Zinc stock is 1.1, and the risk-free interest rate is 5%.
(a) What is the value of this call option? (4 marks)
(b) What is the intrinsic value of the call option? What is the time value of the call option? Interpret these two values. (4 marks)
(c) You would like to replicate this call option using a portfolio of stocks and bonds. What portfolio would you hold? (4 marks)
(d) Calculate the leverage ratio and beta of the call option. Is the option beta higher or lower than Zinc’s stock beta? Based on your answers to part (c), explain the results. (5 marks)
(Total: 17 marks)
Question 5
(a) Steel Corporation currently has $360 million of excess cash. The firm has no debt and 200 million shares outstanding with a current price of $12 per share. The board has decided to use the cash to do a one-timeshare repurchase.
(i) How many shares will be repurchased? What will Steel’s share price be after the repurchase?
(ii) You, as an investor who owns 3,000 shares of Steel stock, would have preferred to receive a dividend payment. Describe what you would do to leave yourself in the same position as if the board had paid a dividend instead. (9 marks)
(b) Iron Corporation currently has no debt on its balance sheet. Iron's marginal tax rate is 30% and the cost of debt is 8%.
(i) Suppose that Iron is going to issue sufficient debt to reduce its taxes by $60 million per year permanently. How much debt does Iron need to issue? What is the total value that can be created (i.e. the value of the interest tax shield)?
(ii) Suppose now Iron plans to borrow $3 billion on a permanent basis through a leveraged recapitalization in which they would use the borrowed funds to repurchase outstanding shares. Investors pay a tax rate of 35% on their interest income and 20% on their income from capital gains and dividends. Calculate the present value of the interest tax shield from this recapitalization from an investor’s perspective. (9 marks)
(Total: 18 marks)
2023-11-23