QUESTION 4 (33 Marks) (a) Explain the term adverse selection and illustrate it with an example...

 

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QUESTION 4 (33 Marks) (a) Explain the term "adverse selection" and illustrate it with an example involving a company that wishes to raise money via a bond issue. (5 marks) (b) (c) (d) (e) With reference to part (a), discuss how adverse selection would affect the cost of capital of a newly issued corporate bond and its subsequent pricing. (6 marks) Suggest THREE (3) solutions that a company that wishes to borrow funds can adopt to mitigate the problem of 'adverse selection'. (9 marks) Recently, Tiger Pharma Co. has raised $500m via a bond issue to fund the research for its new cancer drug. The bond has a par value of $1000, maturity of 6 years and coupon rate of $7%. Upon its issue, the market price of the bond plummeted to $823 within its first week. Based on the information given, what is the yield-to-maturity (YTM) of this bond? (5 marks) With reference to part (d), determine the WACC of Tiger Pharma with the following information: - Corporate tax rate is 28% - Market value of company shares is $2.2 billion (current share price is $56). The dividend per share for next year is $1.90. The company has been growing at a steady rate of 6% and is expected to remain so. - The company has no other outstanding debt, aside from the new bond issue. . (8 marks) QUESTION 4 (33 Marks) (a) Explain the term "adverse selection" and illustrate it with an example involving a company that wishes to raise money via a bond issue. (5 marks) (b) (c) (d) (e) With reference to part (a), discuss how adverse selection would affect the cost of capital of a newly issued corporate bond and its subsequent pricing. (6 marks) Suggest THREE (3) solutions that a company that wishes to borrow funds can adopt to mitigate the problem of 'adverse selection'. (9 marks) Recently, Tiger Pharma Co. has raised $500m via a bond issue to fund the research for its new cancer drug. The bond has a par value of $1000, maturity of 6 years and coupon rate of $7%. Upon its issue, the market price of the bond plummeted to $823 within its first week. Based on the information given, what is the yield-to-maturity (YTM) of this bond? (5 marks) With reference to part (d), determine the WACC of Tiger Pharma with the following information: - Corporate tax rate is 28% - Market value of company shares is $2.2 billion (current share price is $56). The dividend per share for next year is $1.90. The company has been growing at a steady rate of 6% and is expected to remain so. - The company has no other outstanding debt, aside from the new bond issue. . (8 marks)

Answer rating: 100% (QA)

aAdverse selection is a type of information asymmetry that occurs when sellers have information abou... View the full answer