Paper Case

Part A:

a) In finance, risk is uncertainty. Comment (1 sentence) on whether or not Nortel stock is risky, giving a bit of evidence (Hint – think about our homework assignment)

b) The bond rating firms are paid by the corporations and governments that wish to issue bonds. What do investors in bonds worry about, regarding this fact?

c) State ONE advantage and ONE disadvantage of long term corporate bonds compared with long term Treasury (federal government) bonds.

d) State ONE difference between a bond and a preferred share

e) If you sell short 1,000 shares of RIM at $100/share, what is your profit or loss if you cover your short position exactly 2 months later, if the shares are then trading at $130/share?

Answer:

a) Nortel stock price has varied dramatically in recent years (as per our homework assignment), so the stock would be considered very risky.

b) Investors worry about the possibility that the bond rating firms will give bonds a higher rating than they deserve, in order to please their clients – the firms and governments wishing to issue bonds.

c) Corporate bonds have slightly higher yields, but are a little bit more risky than Treasury bonds.

d) Dividends on preferred shares are not contractually required as coupon payments are with bonds OR preferred shares are almost always like perpetuities that pay dividends indefinitely, while bonds almost always mature after a fixed number of years.

e) You were making a bet that the shares would fall, but they increased by $30/share. You will lose $30 x 1,000 = $30,000

Part B:

1. A firm is facing the following situation. The firm has debt of $80 million, which will be due in 1 month. It has no assets or activities happening currently. The firm has two projects it is considering:

Project 1: pays off with $100 million in 1 month, for sure.

Project 2: Pays $50 million in 1 month, with probability 1/3

Pays $100 million in 1 month, with probability 1/3

Pays $150 million in 1 month, with probability 1/3

a) What is the expected outcome for debt-holders and shareholders for each project?

b) Faced with this situation repeatedly, which project would the debt-holders prefer the firm choose? What would the shareholders prefer?

Answer:

a) For project 1, debt-holders expect $80 million