Corporate Finance

Question 1
a) Explain the three theories of cash holdings including: trade-off theory,
pecking order theory and agency conflict theory.
(30 marks)
b) Based on the empirical evidence in Faulkender and Wang (2006) and
Dittmar and Mahrt-Smith (2007), discuss the relationship between the value
of cash holdings and corporate characteristics, including corporate
leverage, cash reserves, financial constraints and the quality of corporate
governance.
(70 marks)
Total: 100 marks
Question 2
a) What is a credit rating game model? What does the credit rating game
model imply about the quality of credit rating?
(40 marks)
b) Discuss how CRAs can monitor and discipline corporate managers with
their credit watch procedure. Your discussion should be supported by the
theory of credit watch in Boot et al. (2006) and the empirical evidence in
Bannier and Hirsch (2010).
(60 marks)
Total: 100 marks
SECTION B
Answer ONE question from this Section
Question 3
a) Dreamline Company is a leading firm in the heavy machines sector,
manufacturing plants for both corporate entities and the government.
Following a successful government policy, Dreamline is in line to win a big
contract to manufacture plants for waste recycling across the country. The
company’s most recent revenue is £2 million per year; this revenue will
potentially increase by 20% or decrease by 25% depending on the outcome
of the bid for the contract. There is an equal probability of the revenue
increase or decrease. It will also cost £1.6 million annually to run the plants.
However, Dreamline has the option to sell the plants to another company
for £5 million. The cost of capital is 10%.
i. Find the value of the plant given the embedded option to sell the
plant.
ii. Assume that Dreamline is not able to sell the plant, but it is able to
shut down the plant at no cost at any time. What is the value of the
option to abandon production?
iii. Assume that it will cost the firm £1 million to shut down the plant, but
it is able to sell the plant for £5 million at any time. Determine the
value of the option to sell the plant.
iv. Draw a decision tree assuming Dreamline is not able to sell the plant,
but it is able to shut down the plant at no cost at any time.
(60 marks)
b) “A complete contract would completely specify every action of every party
to the contract in every state of the world”. However, most real-world
contracts tend to be incomplete. Identify and explain four (4) consequences
of incomplete contracts.