A firm has $100 million in cash on hand and a debt obligation of $100 million due in the next period. With this cash, it can take on one of two projects—A or B—which cost $100 million each.

Assume that the firm cannot raise any additional outside funds. If the economy is favorable, project A will pay $120 million and project B will pay $101 million. If the economy is unfavorable, project A will pay $60 million and project B will pay $101 million. Assume that investors are risk neutral, there are no taxes or direct costs of bankruptcy, the riskless interest rate is zero, and the probability of each state is .5.

a. What is the NPV of each project?

b. Which project will equity holders want the managers to take? Why?

AppendixLO1