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Question 1 (i) Briefly explain the principal-agency problem and can you propose one potential solution to reduce costs associated with this problem? (10 marks) (ii) Specify two typical types of behavioural biases when people make financial decisions. Do you think that the behaviour of buying lottery tickets is consistent with the theory of rational expectations? Explain your answer. (10 marks)

Question 2 (i) Suppose Caterpillar Inc. has 665 million shares outstanding and each share is priced at $74.77. The company has now $25 billion in debt. Assume that Caterpillar maintains a constant debt-equity ratio in the next three years. At the end of the third year, if Caterpillar has 700 million shares outstanding and each share is priced at $83, how much debt will Caterpillar have? (5 marks)

(ii) Alpha plc plans to issue €100 million of bonds with a face value of €50,000, coupon rate of 4 per cent and 10 years to maturity. The current market interest rate on these bonds is 7 per cent. In one year, the interest rate on the bonds will be either 8 per cent with 60 percent probability or 5 per cent with 40 percent probability.

(a) If the bonds are non-callable, what is the price of the bonds today? (10 marks) (b) If the bonds are callable one year from today, will their price be greater than or less than the price you computed in (a)? Discuss your answer from investor’s point of view. (5 marks) (c) If a call price is £50,000, would the firm call the bonds? Please explain your answer (5 marks)

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