Question 1
a)Explain the three theories of cash holdings including: trade-off theory,pecking ordertheory and agency conflicttheory. (30 marks)b)Based on the empirical evidence in Faulkender and Wang (2006) andDittmar and Mahrt-Smith (2007), discuss the relationship between the value of cash holdings andcorporate characteristics, including corporate leverage, cash reserves, financial constraintsand the quality of corporate governance.(70 marks)Total: 100 marks
Question 2
a)What is a credit rating game model? What does the credit rating game model imply about the quality of credit rating?(40 marks)
b)Discusshow CRAs can monitor and discipline corporate managers with their credit watch procedure. Your discussionshould be supported by the theory of credit watch in Boot et al. (2006)and the empirical evidence inBannier and Hirsch (2010).(60 marks)Total: 100 marks
SECTION BAnswer ONEquestion from this Section
Question 3
a)Dream line Company is a leading firm in the heavy machines sector, manufacturing plants for both corporate entities and the government. Following a successful government policy, Dreamline is in line to win a big contract to manufacture plants for waste recycling across the country. The company’s most recent revenue is £2 million per year; this revenue will potentially increase by 20% or decrease by 25% depending on the outcome of the bid for the contract. There is an equal probability of the revenue increase or decrease. It will also cost £1.6 million annually to run the plants. However, Dreamline has the option to sell the plants to another company for £5 million. The cost of capital is10%.i.Find the value of the plant given the embedded option to sell theplant.ii.Assume that Dreamline is not able to sell the plant, but it is able to shut down the plant at no cost at any time. What is the value of the option to abandon production?iii.Assume that it will cost the firm £1 million to shut down the plant, but it is able to sell the plant for £5 million at any time. Determine the value of the option to sell the plant.iv.Draw a decision treeassuming Dreamline is not able to sell the plant, but it is able to shut down the plant at no cost at anytime. (60 marks)b)“A complete contract would completely specify every action of every party to the contract in every state of the world”. However, most real-world contracts tend to be incomplete. Identify and explain four (4) consequences of incomplete contracts. (40 marks)Total: 100 marks
Question 4
a)You are a Chief Financial Officer (CFO) of a Boutique Fashion firm that is ready to enter the leather bagsbusiness.Despitethe coronavirus pandemic,demandforfashionproductsseemstoberisingand you believe that it is right today to enter the business. You also believe that exactly a year from now wouldalsobea good opportunitybecauseofthemassvaccinationtocontainthepandemic.Itwillcost you £35.2 million to enter the market. You can construct a perfectly comparable company to mimic existing public companies in this sector of the fashion industry. Hence, you have decided to use the Black-Scholesformulatodecidewhenandifyoushouldentertheleatherbagsbusiness.Youranalysis impliesthatthecurrentvalueofanoperatingleatherbagscompanyis£40.4million.However,theflow of customers is uncertain, and your analysis indicates a volatility of 25% per year. Twenty percent of the value of the company is attributable to the value of the free cash flows expected in the first year. If the one-year risk-free rate of interest is4.1%:i.Should the Boutique Fashion firm enter this business and, if so,when?ii.How will the decision change if the current value of a leather bag company is £35.6 million instead of £40.4million? (40 marks)
b)Asymmetric information in markets arises where different market participants have different information. Using appropriate examples, discuss the implications of the following concepts:i.adverse selection ii.moral hazard iii.winner’s curse
