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The chief executive officer (CEO) of Faoilean Co has just returned from a discussion at a leading university on the 'application of options to investment decisions and corporate value'. She wants to understand how some of the ideas which were discussed can be applied to decisions made at Faoilean Co. She is still a little unclear about some of the discussion on options and their application, and wants further clarification on the following:

(i) Faoilean Co is involved in the exploration and extraction of oil and gas. Recently there have been indications that there could be significant deposits of oil and gas just off the shores of Ireland. The Government of Ireland has invited companies to submit bids for the rights to commence the initial exploration of the area to assess the likelihood and amount of oil and gas deposits, with further extraction rights to follow. Faoilean Co is considering putting in a bid for the rights. The speaker leading the discussion suggested that using options as an investment assessment tool would be particularly useful to Faoilean Co in this respect.

(ii) The speaker further suggested that options were useful in determining the value of equity and default risk, and suggested that this was why companies facing severe financial distress could still have a positive equity value.

(iii) Towards the end of the discussion, the speaker suggested that changes in the values of options can be measured in terms of a number of risk factors known as the 'greeks', such as the 'vega'. The CEO is unclear why option values are affected by so many different risk factors.

Required With regard to

(ii) above, discuss how options could be useful in determining the value of equity and default risk, and why companies facing severe financial distress still have positive equity values. (10 marks)

2.At times the firms will need to decide if they want to continue to use their current equipment or replace the equipment with newer equipmemt. The company will need to do replacement analysis to determine which option is the best financial decision for the company.

The net present value (NPV) of this replacement project is: $10699, $16405, $14265, $17118

The project involves the following: The new equipment will have a cost of $2,400,000, and it will be depreciated on a straight-line basis over a period of six years (years 1-6). The old machine is also being depreciated on a straight-line basis. It has a book value of $200,000 (at year C) and four more years of depreciation left ($50,000 per year). The new equipment will have a salvage value of $0 at the end of the project's life (year 6). The old machine has a current salvage value (at year 0) of $300,000 Replacing the old machine will require an investment in net operating working capital (NOWC) of $30,000 that will be recovered at the end of the project' life (year 6). The new machine is more efficient, so the firm's incremental earnings before interest and taxes (EBIT) will increase by a total of $300,000 in each of the next six years (years 1-6). Hint: This value represents the difference between the revenues and operating costs (including depreciation expense) generated using the new equipment and that earned using the old equipment The project's cost of capital is 13%. The company's annual tax rate is 40%. ete the following table and compute the incremental cash flows associated with the replacement of the old equipment with the new equipment. Year o Year 1 Year 2 Year 3 Year 4 Year 5 Year 6 $300,000 Initial investment EBIT - Taxes + New depreciation - Old depreciation + Salvage value - Tax on salvage - NOWC + Recapture of NOWC Total free cash flow $580,000.

3.XYZ Company has currently and equity share capital of s 40 lakhs consisting of 40,000 equity shares of Tk. 100 each. The management is planning to raise another Tk. 30 lakhs to finance a major programme of expansion through one of the four possible financing plans.

• Entirely through equity shares

• Tk. 15 lakhs in equity shares of Tk. 100 each and the balance in 8% debentures.

• Tk. 10 lakhs in equity shares of Tk. 100 each and the balance through long-term borrowings at 9% interest p.a.

• Tk. 15 lakhs in equity shares of Tk. 100 each and the balance through preference shares with 5% dividend. The company’s EBIT will be Tk. 15 lakhs. Assuming corporate tax of 50%. Determine the EPS and which financing plan should the firm select?