Name
Corporate finance questions
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Institution
Course
Date
Please solve both exercises
Exercise 1
a. Assume _rst r = zero. Determine the pledge able income and show that the project will be
Funded only if A is sufficiently large
Strategic balance from the perspective of the pledge able income
The condition for pladgeable income is:
The maximum pladgeable income therefore is the optimal leverage is:
b. For the remainder of the problem, assume r > 0. Use (2) to show that, if incentives are
Such that it is optimal for E to shirk in equilibrium, the project will not be funded.
The Equilibrium at which entrepreneurs will try to retain control rights:
at this point, the shirking region is reached
c. Write down E’s incentive compatibility constraint for the two cases: RI < r and RI > r.[Notice that, if RI < r, when the realized return is r, E is paid r????RI and the investors are paid RI . If RI > r, E is paid 0 and the investors are paid r].
“Incentive Compatibility Constraint” (IC)
pHRb _ pLRb + B
Entrepreneur must get at least R_b = R/Dp to behave: The incentive for compatibility constraint is
d. Show that the incentive compatibility constraint is always satisfied when RI < r.
The incentive compatibility constraint involves all the constraint that require agent to act according to the maximization of their interest. The constraint must be accordance to the interest if the agent in addition to meeting the optimality criterion.
ph.u.wH/ – dh/ C .1 – ph/.u.wL/ – dh/
D phu.wH/ C .1 – ph/u.wL/ – dh:
With low effort: phu.wH/ C .1 – pl /u.wL/ – dl . This gives the ph – pl /.u.wH/ – u.wL// _ dh – dl : this is the incentive compatibility constraint
e. Show that if r > I – A, the project will be always funded and that E will always exert high effort. Explain in no more than 200 words the intuition for this result.
The notation is that whenever effort is exerted, the general income per unit of the actual investment
The general assumption is that
Exercise 2
a. Glass98’s CEO has learned that a rival screen manufacturer has made an offer of $10 per screen to AMobile. He would like to know whether his company could match that offer. What would you suggest?
The equilibrium to both the firms receiving the financing
This is because the incentive constraint is stil at
However, the equilibrium to only one firm receiving the financing is
The company can not much glass 98, because, we can chose the corporate level of governance before the send firm
Or we can be competitive to deter the send firm from entering the market or getting finance
the process of predation deterrence can be
b. The CEO argues that your results are determined by the company’s peculiar capital
Structure. If we had a higher debt/equity ratio, comparable to our competitors, our cost of capital would be much lower”. What would you reply to this remark? [Give your answer in no more than 200 words]
While the comment is right, there is lots of downside to it than can be imagined prima facie. For one the company is in a very volatile market segment and may not be able to realize its projected cash flow. On the other hand, the company is operating in a segment, which is marked with competitions from its peers. The debt to equity ratios are based on historical data, which may not be sound basis of decision making. Then debt to equity ratios is likely to be influenced by short term occurrences. The management should consider the following strategies before investing or giving credit to its peculiar capital structure. For example
Maintaining financial flexibility; maintaining financial flexibility is important, as it can be instrumental in enhancing the company’s investment ability
Ensuring long-term survival, the company should also consider approaches that will help it adopt to the changing financial circumstances and regulation instead of maintain its peculiar debt/equity ratio
Maintaining Predictable Source of Funds: the company should look for a source of funds that it can rely on even when making financial projection and investing instead of relying on the traditional sources of funds that is not reliable
Maximizing Stock Price: the company can also maximize its stock price by looking at the future investment opportunity, and considering the incurred business constraints,
Maintaining financial independence or high debt rating and finally trying to maintain the comparability with peer group
c.. Do you agree with the director’s view that the project should be terminated?
The project was an investment and all investment has teething problems, most projects fail to break even on the second year of initiation. The management should give the project a second consideration because after the second year the projects net present value will reach a positive high. On the other hand, the Payback period may be over but the IRR may exceed the required rate of return on the third year of operation. However, while the director view is worth considering, he should note that the value of the dismantled production line may not be enough to defray the accumulated cost or the cost initial cost of purchasing the equipment, the depreciation rate may be high and the company may not shoulder the burden (Tiroley, 2000).
Bibliography
Tiroley, J, (2000). “Corporate Governance,” CEI Working Paper Series 2000-1, Center for Economic Institutions, Institute of Economic Research, Hitotsubashi University.
