EC3340
1 (Continued overleaf)
UNIVERSITY OF WARWICK
Summer Examinations 2021/22
Topics in Financial Economics: Corporate Finance and Markets
Time Allowed: 2 Hours
Read all instructions carefully - and read through the entire paper at least once before you
start entering your answers.
There are TWO sections in this paper. Answer ONE question in Section A (50 marks) and
ONE question in Section B (50 marks).
Approved pocket calculators are allowed.
You should not submit answers to more than the required number of questions. If you do,
we will mark the questions in the order that they appear, up to the required number of
questions in each section.
Section A: Answer ONE question
1. A firm is planning to create an electric vehicle Gigafactory on a disused airport site near
Coventry. This will have either 100 or 250 assembly machines. The current net revenue
per machine is £28,000.
Next year this will either rise to £37,500 (in the ‘good state’ which has probability 65%)
or fall to £11,500 (in the ‘bad state’ which has probability 35%) - and stay there forever
after. The variable cost of constructing the gigafactory is currently £170,000/machine
(for either a small or large facility) plus a fixed cost of £5,000,000 for a small facility or £29,000,000 for a large facility. Assume that construction is instantaneous (so a factory
built this year will generate revenues of £28,000/machine this year as well as revenues
in all subsequent years at whatever the revenue turns out to be). The risk-free interest
rate is 10%.
(a) If the firm must decide today, what will it do and how much will it get? (15 marks)
(b) Suppose the firm could purchase an option to delay the decision by one year,
assuming that the variable cost of construction would drop to £160,000 per
machine in the good state and rise to £200,000 per machine in the bad state. You
should assume that these costs – and the fixed costs, which do not change - are
paid next year, when and if the factory is constructed. What would the firm’s
optimal choice next year be if it purchased this option, and how much would the
firm be willing to pay for the option? (35 marks)
EC3340
2 (Question 3 continued overleaf)
2. Consider the Modigliani-Miller world:
(a) What conditions must hold for leverage not to affect the market value of the firm
(what defines a perfect market)? (10 marks)
(b) In a perfect market, what is the effect of increasing the proportion of debt in a
firm's asset base (increasing gearing) on the cost of each of the following? (Explain
your answers.)
(i) Debt; (5 marks)
(ii) Equity; (5 marks)
(iii) Overall cost of capital? (5 marks)
(c) Explain (in words or by example) how the firm's shareholders could:
(i) Gain by investing in a project with negative Net Present Value (NPV < 0);
(3 marks)
(ii) Lose by investing in a project with positive NPV; (3 marks)
(iii) Gain if the firm pays out a large cash dividend; (2 marks)
(iv) Lose if the firm repurchases some of its shares. (2 marks)
(d) According to Modigliani-Miller, a perfect market can 'undo' the effects of a firm's
financial policy (mix of debt and equity).
(i) How can traders in the market mimic the effects of an increase in debt (higher
leverage) and why might they want to do this? (5 marks)
(ii) How would your answer change with costly bankruptcy? (5 marks)
(iii) When a firm ‘goes private’ (transfers control to private equity) it normally takes
on a lot of debt – how would this affect your answers to (i)-(ii)? (5 marks)
Section B: Answer ONE question
3. A hedge fund is interested in taking over a formerly-profitable local railroad, hoping to
benefit from a post-Covid return to commuting. The railroad’s profits are determined by
demand (a random parameter distributed uniformly on [0, 1]) and by their effort .
The profit function is , the cost of effort is
2
2
and the existing management’s outside
option ̅ > 0. The hedge fund wants to specify a contract paying the existing managers
bonuses of – in other words, if the railroad produces profit the investors get −
and the managers get . The managers must accept or reject the contract before
observing  but choose effort after observing it. All parties are risk neutral.
EC3340
3 (End)
(a) Assume the hedge fund can observe , but cannot separately observe or .
Bonuses are computed as a proportion of profits: = where is a (not
necessarily positive) parameter. Find the managers’ optimal effort as a function of
, ̅ and and use this to compute the value of that maximises the hedge funds’
expected utility. Also, find the optimised expected value of the railroad as a
function of ̅. (20 marks)
(b) How (if at all) would your answer differ if the managers observed before
accepting or rejecting the contract? Please explain your reasoning. (15 marks)
(c) Now suppose that the hedge fund must pay off the managers before observing
actual profits , but that they have the opportunity to audit (observe) either the
random state or effort , but not both. In other words, they can choose a contract
that depends on ( = for some ‘profit share’ ) or one that depends on
( = for some ‘effort wage’ ), but not both. As before, the managers accept
or reject the offer before observing . Which would the investors prefer to
observe? Please explain your answer in detail. (15 marks)
4. "Credit default swaps are destabilising to financial markets and should be limited to a
fixed proportion of the face value of the underlying credit.” Discuss. (50 marks)