Instructions to students:  All questions are compulsory.

Materials:

Dictionaries are not permitted.

TASK: L140 Econometrics Assignment

Question 1.

Company Dilemma Ltd. faces a choice between two mutually exclusive investment projects. The company has £100 million in outstanding debt, which need to be repaid one year from now. The interest rate on the debt is 5%, which is 1% more than the risk free rate. The market premium is expected to be 6%. Both possible projects require an initial investment of £10 million, which will be written o¤ entirely (i.e. full depreciation) after one year. Both projects generate cash  for one year only. Project A has a 50% chance of success, in which case it generates a cash ‡ow £40 million. If the project does not do well it generates £10 million. Project B has a success rate of 30% and generates £100 million in cash and £0 if it does not succeed. The project is A= 1 and B= 2 for projects A and B respectively. The corporate tax rate is 40%. Assume that the company has currently no other projects running, but it has assets worth £90 million that can be liquidated at that value at any time.

a)Which of the two projects, if any, should the company undertake? Support your answer with the necessary calculations.

b)Suppose now that the manager undertaking the project acts on behalf of the shareholders only, and the project is financed by a £10 million injection of new equity by existing shareholders. Which project, if any, will the manager choose? Comment on your findings.

c)How might the financing choice affect your answer to (b).