Assorted Corporate Finance Questions

1. A gold company owns a gold mine which can produce 1 million oz of gold and it takes
one year to extract the gold at a cost of $1000 per oz. The gold price now is $1200
per oz and it will either increase to $1600 per oz or decrease to $900 per oz with equal
probability next year and stay there forever. Assume that the gold price risk is totally
diversiable. The risk-free rate is 2%.
(a) What is the NPV of this gold mine if the company extracts the gold now?
(b) If the company can wait for a year to decide and they can abandon the gold mine,
what is the optimal strategy and how much is this abandonment option worth?
2. Willy Wonkas Chocolate Factory is capable of producing both candy and chocolate for
the next 3 years. Since it is inecient to produce both at the same time, Willy Wonka
must choose one of the two at the beginning of each year. For the upcoming year,
revenues for candy and chocolate are known to be $80 and $79.5 million, respectively.
In each subsequent years, revenues for the two products will either both increase or
both decrease with equal probabilities. Revenues for candy either go up by 5% or down
by 2%, and the corresponding changes in the revenue for chocolate are 9% and 5%.
Production costs are $50 million per year for both products, and this gure increases
by $2 million if there is a switch in production from the previous year. The Factory
opens today, operates for three years and permanently close thereafter. All revenues
and costs are incurred at the end of the year. There are no taxes. The risk-free rate is
1%. The stock price in each year either goes up by 5% or down by 2%.
(a) What are the NPVs for producing candy and chocolate exclusively for all three
years?
(b) What is the optimal production schedule? Specify the optimal decision at each
node.
(c) What is the value of the exibility option, i.e., the ability to choose production?
3. Company ND Inc is a small software company which has very volatile cash ows. As
a result, it has no debt outstanding. Its cost of capital is 15%. It is now deciding
between two new projects, A and B (can only take one). They have the following cash
ows (in million dollars), respectively:
The good and bad outcomes are equally likely and the risks are idiosyncratic for both
projects. The risk-free interest rate is 10%. The corporate tax rate is 50%. All cash
ows are after-tax.
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(a) What is the NPV of these two projects, respectively. What discount rates will
you use and why if you believe CAPM?
(b) If ND uses 100% equity nancing, which project should it choose?
(c) Can ND consider using some risk-free debt nancing? If no, explain. If yes, how
much debt nancing should it use and would it change the choice between the
two projects?
4. Company ABC is worth $100 million today and we have two states with equal prob-
ability one year later. ABC will be worth $200 million in the upper state and $60
million in the down state. Moreover, ABC has $80 million debt due next year so that
in the down state, the company will bankrupt which costs another $10 million(distress
cost). Assume that the discount rate is 0.
(a) Give some examples of distress costs in real life.(Direct and indirect)
(b) Now ABC has a project which needs $20 million investment today and has $30
million revenue in the upper state and $15 million in down state. NPV of this
project is positive. Will ABC invest in this project? If not, why doesnt ABC
invest in positive NPV project? Assume that equity holders have the right to
make investment decision and the project is totally nanced by equity.
(c) Suppose now ABC has $80 million long term debt(due in 10 years), does it change
your answer in part (a)? Explain why.
(d) Now ABC has another project which needs $20 million investment today and has
$50 million revenue in the upper state and -$15 million in down state. Whats
the NPV of this project and will ABC invest in it? Explain why. Assume again
that equity holders have the right to make investment decision and the project is
totally nanced by equity.
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