Finance 2 (2023) – Problem Set 6 (Week 7)
University of Amsterdam
Answers to IN CLASS exercises do not need to be handed in
The parts of exercises marked [IN CLASS] (e.g. 2d-2f) will be completed during the tutorial
and answers to these parts do not need to be handed in via Canvas. Answers to the other
questions need to be completed before the deadline (see Canvas) and students need them
to participate in the tutorial.
Grading: only first problem set and bonus
We will only grade the first homework set in Canvas and then at the end of the course
determine if you have received the bonus or not. You will therefore not see a grade for
each homework set you have handed in. Feedback is possible during the tutorials.
Question 1 – Chapter 22 - Real options
You want to start an off-shore business in Venezuela, a country where the level of political stability
will influence the prospects of the business. You have the opportunity to invest straight away in new
facilities which will cost you $6.0 million upfront. This investment will generate a FCF at the end of
each year forever that can be either $800,000 (when political stability is high) or $250,000 (when
political stability is low), each with 50% probability.
If you do not invest immediately you have the real option to postpone the investment for one year
giving you precise information about the political stability in the country. After postponing the
investment you know for sure if stability is high or low with corresponding cash flows as mentioned
above. The appropriate discount rate for this project is 12% per year.
a) Draw the decision tree (with choices and cash flows) for the offshore business including the
decision to postpone the investment by one year.
b) What is the NPV of the project today if the company decides not to wait?
c) What is the NPV of the project today if the company decides to wait 1 year?
d) Would you advise the company to wait or not?
e) What is the value of the real option imbedded in this situation?
Question 2 – Chapter 29 - Managerial Compensation
a) Define the concept of corporate governance. In what situations is corporate governance
needed?
b) If you could design a compensation package for the CEO, how would you construct this
package and why?
c) Does linking management compensation to stock performance incentivize managers to act
in interest of the company? Explain why or why not.
1
,d) What are downsides of having the pay of managers linked to the stock price? [IN CLASS]
e) Does the threat of a hostile takeover increase or reduce the likelihood that managers
behave in the interests of shareholders? Explain your answer. [IN CLASS]
f) Find an example in the news of a situation in which the corporate governance mechanism of
a company clearly failed. What could have been done to prevent this situation? [IN CLASS]
2
, Problem set 6
You want to start an off-shore business in Venezuela, a country where the level of
political stability will influence the prospects of the business. You have the opportunity
to invest straight away in new facilities which will cost you $6.0 million upfront. This
investment will generate a FCF at the end of each year forever that can be either
$800,000 (when political stability is high) or $250,000 (when political stability is low),
each with 50% probability.
If you do not invest immediately you have the real option to postpone the investment for
one year giving you precise information about the political stability in the country. A er
postponing the investment you know for sure if stability is high or low with
corresponding cash flows as mentioned above. The appropriate discount rate for this
project is 12% per year.
Question 1
a.
University of Amsterdam
Answers to IN CLASS exercises do not need to be handed in
The parts of exercises marked [IN CLASS] (e.g. 2d-2f) will be completed during the tutorial
and answers to these parts do not need to be handed in via Canvas. Answers to the other
questions need to be completed before the deadline (see Canvas) and students need them
to participate in the tutorial.
Grading: only first problem set and bonus
We will only grade the first homework set in Canvas and then at the end of the course
determine if you have received the bonus or not. You will therefore not see a grade for
each homework set you have handed in. Feedback is possible during the tutorials.
Question 1 – Chapter 22 - Real options
You want to start an off-shore business in Venezuela, a country where the level of political stability
will influence the prospects of the business. You have the opportunity to invest straight away in new
facilities which will cost you $6.0 million upfront. This investment will generate a FCF at the end of
each year forever that can be either $800,000 (when political stability is high) or $250,000 (when
political stability is low), each with 50% probability.
If you do not invest immediately you have the real option to postpone the investment for one year
giving you precise information about the political stability in the country. After postponing the
investment you know for sure if stability is high or low with corresponding cash flows as mentioned
above. The appropriate discount rate for this project is 12% per year.
a) Draw the decision tree (with choices and cash flows) for the offshore business including the
decision to postpone the investment by one year.
b) What is the NPV of the project today if the company decides not to wait?
c) What is the NPV of the project today if the company decides to wait 1 year?
d) Would you advise the company to wait or not?
e) What is the value of the real option imbedded in this situation?
Question 2 – Chapter 29 - Managerial Compensation
a) Define the concept of corporate governance. In what situations is corporate governance
needed?
b) If you could design a compensation package for the CEO, how would you construct this
package and why?
c) Does linking management compensation to stock performance incentivize managers to act
in interest of the company? Explain why or why not.
1
,d) What are downsides of having the pay of managers linked to the stock price? [IN CLASS]
e) Does the threat of a hostile takeover increase or reduce the likelihood that managers
behave in the interests of shareholders? Explain your answer. [IN CLASS]
f) Find an example in the news of a situation in which the corporate governance mechanism of
a company clearly failed. What could have been done to prevent this situation? [IN CLASS]
2
, Problem set 6
You want to start an off-shore business in Venezuela, a country where the level of
political stability will influence the prospects of the business. You have the opportunity
to invest straight away in new facilities which will cost you $6.0 million upfront. This
investment will generate a FCF at the end of each year forever that can be either
$800,000 (when political stability is high) or $250,000 (when political stability is low),
each with 50% probability.
If you do not invest immediately you have the real option to postpone the investment for
one year giving you precise information about the political stability in the country. A er
postponing the investment you know for sure if stability is high or low with
corresponding cash flows as mentioned above. The appropriate discount rate for this
project is 12% per year.
Question 1
a.
