Consider a firm that will liquidate one period hence at time t = 1. There are no taxes and the firm can invest $30 in a risky venture at t = 0 using retained earnings. If the investment is not made, shareholders get a dividend of $100 at t = 0. The firm’s debt requires a payment of $100 at t = 1, and its investment choices are described in Table 1.3.

For simplicity, assume that the discount rate is zero. What should the firm do?

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TABLE 1.3 Payoffs Related to Different Investment Opportunities Strategy Total firm value at t = 1 if no investment made and $100 dividend paid at t = 0 Total firm value at t = 1 if $30 investment made and $70 dividend paid at t = 0 Boom (with probability 0.5) $110 $200 State of Nature Bust (with probability 0.5) $70 $5