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Question 1:

The two formats fighting for supremacy as the next-generation videodisc format are HD-DVD (developed by Toshiba and NEC) and Blu-Ray (developed by Sony). For the rest of this problem consider Sony as being composed of two assets: Playstation 3, in which Sony has already invested and a Blu-ray project in which Sony has not yet invested. Currently the market believes it is equally likely that Blu-ray could be successful (stateS) or fail (state F). The table reports the value of the Playstation 3 assets and the NPV of the Bluray project in each state of the world. Sony's Blu-ray project requires an investment of $75 million independent of the state. Assume that managers try to maximize the wealth of original shareholders.

(State S) (State F)

Playstation 3 (assets-in-place) 130 50

NPV 15 5

[ Blu-ray project]=PV[Cashflows]-75

A) To fund their project, Sony must raise $75 million in equity (no bank will lend against such intangible assets). If managers must issue equity prior to knowing which technology is superior, what percentage of the firm must original equityholders give up in exchange for the capital? Round your answer to the nearest percentage.

B) Sony is an all-equity firm. If there had been debt in their capital structure, maturing after all projects are to be completed, would this raise or lower the percent of the equity demanded by the outside investors? Explain briefly. Assume all the other numbers remain unchanged.

C) If Sony's managers knew whether Blu-Ray would be successful but the market did not, would they always raise equity and invest in the Blu- Ray project? Explain completely showing relevant calculations. Assume equity capital can be raised under the terms which you calculated in A).

D) Prior to Sonys management learning about the success of Blu-Ray technology, Bethea & Associates (B&A) approached Sony with an innovative financing proposal. B&A are private equity investors and have offered to invest $75M in Sony equity, ifSony feels the public market is mispricing their equity. As B&A will carefully investigate the value of Sony's assets, assume that the private equity issue will be correctly priced. B&A wants a $7M fee to cover their costs. Should Sony agree to B&As terms?

E) Now suppose that Sonys management is unlikely to know with certainty whether the Blu-Ray technology is a success before they have to invest. However, early technical results will give them imperfect information on the projected success of Blu-Ray technology. If the preliminary tests results are positive, there is a 60% chance that Blu-Ray will succeed (i.e. State S will occur). If the preliminary test results are negative there is a 40% chance that Blu-Ray will succeed. If they do not invest now, they cannot invest later. Assuming we can issue equity at the terms described in part A, should Sonys management sell equity and invest in the Blu-Ray project based on the early technical results? Explain completely.

Question 2:

United Airlines is thinking about beginning perpetual service between Chicago - and Buenos Aires. To enter this market, United must purchase a newaircraft. They are considering the purchase of a 757 which can carry 200 passengers or a 747 which can carry 400 passengers. Assume that the aircraft last forever with no depreciation. The prices and operating costs of the two aircraft models are shown below.

Boeing 757 Boeing 747

Purchase Price $55 million $105 million

Annual Operating Cost $15 million $20 million

Passenger Capacity 200 400

The primary source of uncertainty facing United is the level of demand. First year demand is known with certainty - 200 round-trip passengers per day. However, demand in subsequent years is uncertain. With 50% probability, next years demand will increase to 400 round-trip passengers per day and will remain at 400 in all subsequent years. With 50% probability, demand wil lstay at 200 round-trip passengers per day forever. Revenue is regulated to be $0.25 million annually per daily round-trip (or $50 million annually per 200 daily round-trips). For simplicity, assume that first year cash flows are received immediately, next years cash flows are received one year from now, and so on. Further assume that there is no competition and the appropriate discount rate is 10%.

A) Expected demand next year (and every year thereafter) is 300 round- trips per day. Using this expected level of demand, calculate the Net Present Value of purchasing the 747. Remember, the first years revenues and costs occur immediately.

B) If the 757 is purchased this year, an additional 757 aircraft will have to be purchased next year to meet the expected demand of 300 round- trips per day. Suppose that United's decision to take delivery of the second 757 must be madetoday, but they pay for the aircraft next year (when its delivered). Assuming that United commits to taking delivery of the second 757 next year, what is the NPV associated with using 757s to serve the Chicago Buenos Aires route?

C) Suppose that Boeing offers to waive the requirement that United commit to the purchase of the second 757 immediately. What is the maximum amount United should pay for this waiver?

The requirement is to solve all the parts oc both questions.