ACF315 - International Financial Management - University of Plymouth

Question 1. Suzhou Corporation is about to launch a new product. Depending on the success of the new product, Suzhou may have one of four values next year: $150 million, $135 million, $95 million, or $80 million. These outcomes are all equally likely, and the risk is completely diversifiable. Assume the risk-free interest rate is 5% and that, in the event of default, 25% of the value of Suzhou's assets will be lost to bankruptcy costs. (Ignore all other market imperfections, such as taxes.)

a. What is the initial value of Suzhou's equity without leverage?
Now suppose Suzhou has zero-coupon debt with a $100 million face value due next year.
b. What is the initial value of Suzhou's debt?
c. What is the yield-to-maturity of the debt? What is its expected return?
d. What is the initial value of Suzhou's equity? What is Suzhou's total value with leverage?
Suppose Suzhou has 10 million shares outstanding and no debt at the start of the year.
e. If Suzhou does not issue debt, what is its share price?
f. If Suzhou issues debt of $100 million due next year and uses the proceeds to repurchase shares, what will its share price be? Why does your answer differ from that in part (e)?

Question 2. a. Explain the difference between hedging and speculation?
b. Briefly explain the difference between beta as a measure of risk and variance as a measure of risk.
c. AB Corporation has just received good news: Its earnings increased by 10% from last year's value. Most investors are anticipating an increase of 5%. Briefly explain what will happen to the AB's stock price when the market opens and assuming market is efficient.

Question 3. Suppose you work for Oracle Corporation, and part of your compensation takes the form of stock options. The value of the stock option is equal to the difference between Oracle's stock price and an exercise price of $10 per share at the time that you exercise the option. As an option holder, would you prefer that Oracle uses dividends or share repurchases to pay out cash to shareholders? Explain.

Question 4. You would like to estimate the weighted average cost of capital for a new airline business. Based on its industry asset beta, you have already estimated an unlevered cost of capital for the firm of 9%. However, the new business will be 25% debt financed, and you anticipate its debt cost of capital will be 6%. If its corporate tax rate is 40%, what is your estimate of its WACC?