01. Options and Investment Decisions (EXAM2122)
Answer the following questions:
(a)
G-Star has a zero coupon bound issue outstanding with a $10,000 face value that
matures in one year. The current market value of the firm’s assets is $11,200. The
standard deviation of the return on the firm’s assets is 38% per year and the annual
risk free rate is 5% per year, compounded continuously. Based on the Black-Scholes
model, what is the market value of the firm’s equity and debt.
(b)
Suppose the firm in the previous problem is considering two mutually exclusive
investments. Project A has an NPV of $1,200 and Project B has an NPV of $1,600. As
a result of taking Project A, the standard deviation of the return on the firm’s assets
will increase to 55% per year. If project B is taken, the standard deviation will fall to
34% per year. What is the value of the firm’s equity and debt if Project A is undertaken?
If project B is undertaken? Which project would the stockholder prefer? Can you
reconcile your answer with the NPV rule?
(c)
If the stockholders and bondholders in G-Star are, in fact, the same group of the
investors. Would this affect your answer to (b) What does this problem suggest to you
about stockholder incentives?
(d)
A large conglomerate (multi-division company) is critiqued by one equity analyst
about the company’s focus on diversifying its business risk through investing
aggressively in companies of many different business sectors. The analyst claimed
that investors can achieve the diversification more efficiently by themselves.
Assess the rationale behind this statement based on the concept of diversification.
02. Capital Structure & Dividends (EXAM2021)
Strong Inc. has evaluating its capital structure. The balance sheet of the company is
shown below (in millions of $):
Assets
Liabilities
Current Assets
1,000
Debt
2,500
Non-current Assets 4,000
Equity
2,500
In addition, you are provided the following information:
The debt is in the form of long-term bonds, with a coupon rate of 10%. The bonds are
currently rated AA and are selling at a yield of 12% (The market value of the bonds is
80% of the face value). The firm currently has 50 million shares outstanding, and the
current market price is $80 per share. The firm pays a dividend of $4 per share and has
a price/earning ratio of 10. The stock currently has a beta of 1.2. The market risk
premium is 8%. risk free rate is 4%. The tax rate for this firm is 40%.
(a)
Calculate the firm’s debt/equity ratio in book value terms and in market value
terms? Calculate the firm’s after-tax cost of debt, the firm’s cost of equity and
the firm’s current cost of capital?
(b)
The firm is considering a major change in its capital structure. It has three
options:
- Option 1: Issue $1 billion in new stock and repurchase half of its outstanding
debt. This will make it an AAA rated firm (AAA rated debt is yielding 11% in
the marketplace).
-
Option 2: Issue $1 billion in new debt and buy back stock. This will drop its
rating to A. (A rated debt is yielding 13% in the marketplace).
-
Option 3: Issue $3 billion in new debt and buy back stock. This will drop its
rating to CCC (CCC rated debt is yielding 18% in the marketplace).
Calculate the cost of equity, after-tax cost of debt and cost of capital of each of the
three options? What would happen to (i) the value of the firm; (ii) the value of debt
and equity; and (iii) the stock price under each option if you assume rational
stockholders? From a cost of capital standpoint, which of the three options would you
pick, or would you stay at your current capital structure? Intuitively, why doesn’t the
higher rating in option 1 translate into a lower cost of capital?
(c)
Discuss what additional factors you need to consider if the money under the two
options were used to take new investments (instead of repurchasing debt or
equity)?
3. Options (EXAM2021)
Answer the following questions:
(a)
Walter Maxim, the CEO of Digital Storage Devices has been granted options on
300,000 shares. The stock is currently trading at $27 a share and the options are at the
money. The volatility of the stock has been about .15 on an annual basis over the last
several years. The options mature in 5 years, become exercisable in 3 years, and the risk
free rate is 4%. What is the value of Mr. Maxim's options? Why would the company pay the
executive in options as opposed to salary?
(b)
If Mr. Maxim earned $500,000 in regular annual salary why might he prefer to have
$1,500,000 in straight salary versus salary and options?
(b)
There is a European call option on a stock that expires in two months. The stock
price is $73, and the standard deviation of the stock returns is 70%. The option has a
strike price of $75, and the risk free interest rate is 5% per annual. What is the price of
the call option today using one-month step?