EC3340 Topics in Financial Economics: Corporate Finance and Markets 2020/21
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EC3340
Summer Examinations 2020/21
Topics in Financial Economics: Corporate Finance and Markets
1. A property developer is considering taking advantage of the current increase in people working from home. It believes that it is possible to create a block of 500 new ‘personal distance’ offices with high-speed interconnections and ‘smart rooms’ that will be attractive to employers once the pandemic threat recedes. The current estimate of the rental revenue per office unit per year is £41,250. The cost of servicing each office unit is £20,000 per year. The riskless rate of return – which is used by the project planners to discount all monetary flows - is 5%. If the project is undertaken this year, it will cost £67.5 million and generate revenue starting now. Once built, the offices are expected to
generate the same annual costs and revenues forever.
(a) What is the NPV if the project is undertaken now? (10 marks)
(b) Now suppose that next year, when the current uncertainty is resolved, the rental
revenue per unit per year is expected either to rise to £90,000 (the recovery state, with probability 25%) or to fall to £25,000 (the ‘long Covid’ state, probability 75%) – and to remain at that level forever. If the decision about whether to build the offices is delayed till next year, the project cost will change - to £75 million in the recovery state or £52 million in the long Covid state, but the annual servicing cost will remain at £20,000 per unit per year. What is the NPV if the project is delayed?
(15 marks)
(c) When (if at all) should the project be undertaken and what is the option to delay the project worth to the developer? (10 marks)
(d) A university student living in the town points out that the project is risky (at least in the first year). How would you take this into account? (Be as specific as you can about the method and the implications for valuing the option to delay.) (15 marks)
2. “The growing availability of data and the use of technical and ‘big data’ analysis tools will make capital markets (strong-form) efficient.” Discuss whether this is true and the implications for market regulation. (50 marks)
3. A government procurement officer is trying to decide how many doses of a new coronavirus vaccine to order. This decision will depend on the effectiveness of the vaccine, which will be determined by clinical trials conducted by a scientific advisor. You may assume that the effectiveness of the vaccine is given by a random variable ,ߝuniformly distributed on the interval [ .]1 + ⃞⃞ ,⃞⃞The scientific advisor believes the utility of quantity ⃞ (measured in millions of doses) is ⃞⃞(⃞|⃞ − ⃞ߝ + 1 = )ߝଶ; if perfectly informed about effectiveness, the procurement officer would value ⃞ at ⃞ − ⃞)ߚ + ߝ( + 1 = )ߝ|⃞(ீ⃞ଶ where ߚis a non-negative constant. After the trials, the government officer asks the scientific advisor to report on the vaccine’s effectiveness and purchases the quantity that maximises the procurement officer’s expected utility. The scientific advisor is not paid for their efforts, but seeks to maximise ⃞⃞ .
(a) How would you set up this problem? Can the scientific advisor be sure that the
government will purchase the optimal quantity (according to the scientific advisor’s preferences)? If so, how? If not, why not? How does your answer depend on the size of (15 ?ߚmarks)
(b) Suppose that the minimum effectiveness is 25%, = ⃞⃞and that .%5 = ߚFind the
‘babbing equilibrium’ for this situation – how much will the government order and what expected utilities will the two parties get? (7 marks)
(c) Now construct a two-part equilibrium – depending on the advice they receive the government will place either a small order ⃞ௌ or a large order ⃞⃞ . At what reported level of effectiveness will the government switch its order size, and what are the values of ⃞௦ and ⃞⃞? (10 marks)
(d) How would you find the most efficient equilibrium (you do not have to compute it explicitly, but should say how it could be identified)? (10 marks)
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(e) Finally, suppose the government became convinced that vaccine orders were an essential part of the economic recovery plan and thus shifted ߚto −5% (meaning that in any given state the government would like to see a larger order than the advisor would recommend). If the government could pre-commit to an order scheme (regardless of whether it maximises its expected utility), what would you expect the optimal scheme to look like (again, you do not have to compute it explicitly)? (8 marks) |
4. |
Many commentators have linked financial innovation – especially the trade in novel derivatives – to recent episodes of market instability, volatility and even inefficiency. Others see them as an essential way to make up for market incompleteness by allowing existing assets to be combined in ways that enable investors to replicate arbitrary patterns of returns. Discuss, with examples, problems associated with the valuation of and trade in derivatives, paying particular attention to structured debt and the role of ratings agencies. What, if any, are the implications for the linkage between financial markets and the real economy? (50 marks) |
2022-05-06