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10. In a risk-neutral world with zero interest rates, we consider a Danish company that has assets worth DKK 12.5m. The firm's capital structure is
10. In a risk-neutral world with zero interest rates, we consider a Danish company that has assets worth DKK 12.5m. The firm's capital structure is 80% debt and 20% equity. The assets of the firm have just become free to be invested. The shareholders evaluate two opportunities for using the DKK 12.5m to produce and export a new product: (i) produce 130 units, ship them to Norway, sell them for NOK 100,000 each. (ii) produce 100 units, ship them to China, sell them for CNY 80,000 each. After doing some research on the current situation in currency markets, the firm expects that the DKK/NOK exchange rate will be with equal probabilities either 0.99 or 1.01. The exchange rate situation for China is very uncertain. The firm believes that the probability that China gives in and substantially revalues its currency is 25%, which would result in an exchange rate of DKK/CNY 3. Otherwise, the firm expects the DKK/CNY to be more or less unchanged at around DKK/CNY 1. (a) Evaluate the two competing projects. Which one would shareholders choose? (b) Why would bondholders try object to the shareholders' choice? (c) Would the shareholders' project preference change if they were forced to hedge foreign exchange risk? 10. In a risk-neutral world with zero interest rates, we consider a Danish company that has assets worth DKK 12.5m. The firm's capital structure is 80% debt and 20% equity. The assets of the firm have just become free to be invested. The shareholders evaluate two opportunities for using the DKK 12.5m to produce and export a new product: (i) produce 130 units, ship them to Norway, sell them for NOK 100,000 each. (ii) produce 100 units, ship them to China, sell them for CNY 80,000 each. After doing some research on the current situation in currency markets, the firm expects that the DKK/NOK exchange rate will be with equal probabilities either 0.99 or 1.01. The exchange rate situation for China is very uncertain. The firm believes that the probability that China gives in and substantially revalues its currency is 25%, which would result in an exchange rate of DKK/CNY 3. Otherwise, the firm expects the DKK/CNY to be more or less unchanged at around DKK/CNY 1. (a) Evaluate the two competing projects. Which one would shareholders choose? (b) Why would bondholders try object to the shareholders' choice? (c) Would the shareholders' project preference change if they were forced to hedge foreign exchange risk
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