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Question 1 You are operating a gold mine that will extract 1 0 tons of gold per year for the next twelve years. You expect
Question
You are operating a gold mine that will extract tons of gold per year for the next twelve years. You
expect to sell the extracted gold for a perton price of $ million every year for the next six years. For the
final six years, you expect to sell the extracted gold for an uncertain perton market price of either $M
percent probability or $M percent probability Assume that the cost of extracting each ton of
gold is $ million for all years.
a Suppose that the riskfree rate is percent and the market risk premium is percent. Retrieve
the beta of gold by looking up the primary gold exchange traded fund symbol: GLD on Yahoo!
Finance. What is the expected return on gold? This will be used as your discount rate on your gold
mining operations.
b What is the value of your gold mining operation? This is calculated as the present value of
expected future revenues minus the present value of future costs.
You will learn at t whether the perton gold price for the last six years will be $M or $M
c Now assume that you have the option at t to ramp down gold production to three tons per year
for the last six years of operations. Illustrate why you would only ramp down production to three
tons per year if the gold price ends up being $M per ton for the final six years.
d What is the value of your gold mining operation at t given that you have the option at t to
ramp down gold production to three tons per year for the final six years of operations?
Question
When a firm has cash flow problems, there are often negative feedback effects. For example, the firm
may need to cut capital expenditures and research and development activities that are necessary to
remain competitive in its industry.
Your firm, Goldmine Incorporated, is considering the purchase of a foreign technology firm called
ForeignTechs. Goldmine is considering this purchase because ForeignTechs tends to have a good year
when Goldmine has a bad year. If Goldmine purchased ForeignTechs, then Goldmine would not have cash
flow problems in its bad years because ForeignTechs can provide support in those years.
The following table outlines the possible cash flows produced by Goldmine and ForeignTechs each year:
State A State B State C
Probability
Goldmine Cash Flow $M $M $M
ForeignTechs Cash Flow $M $M $M
Assume that Goldmine incurs an additional cost of $M in State A because of the negative feedback
effects resulting from the cash flow problems in that state. If Goldmine purchases ForeignTechs, then
Goldmine would not incur this additional $M cost in State A The annual expected return on Goldmine
assets is percent and the expected return on ForeignTechs assets is percent. Both firms are allequity and will operate in perpetuity. Each firm has M shares outstanding.
a Assume that no merger announcement has been made. What is the share price of each firm?
Goldmine announces it will purchase all of the shares in ForeignTechs. Following the purchase of
ForeignTechs, Goldmine announces to the public that it will no longer incur the additional $M cost in
State A because of the implicit insurance provided by ForeignTechs.
b What is the value of the combined firm?
c Is the merger a good idea? For this, you will have to compare the value created from the merger
to the value of the standalone firms.
d If the merger is a good idea, why might Goldmine encounter resistance from ForeignTechs
national government?
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