A firm has a senior bond obligation of $20 due this period and $100 next period. It also has a subordinated loan of $40 owed to Jack and Jill and due next period. It has no projects to provide cash flows this period. Therefore, if the firm cannot get a loan of $20, it must liquidate. The firm has a current liquidation value of $120. If the firm does not liquidate, it can take one of two projects with no additional investment. If it takes project A, it will receive cash flows of $135 next period, for sure. If the firm takes project B, it will receive either cash flows of $161 or $69 with equal probability. Assume risk neutrality, a zero interest rate, no direct bankruptcy costs, and no taxes.

a. What has a higher PV: liquidating, project A, or project B?

b. Should Jack and Jill agree to loan the firm the

$20 it needs to stay operating if they receive a

(subordinated) bond with a face value of

$20.50?

c. If the firm does receive the loan from Jack and Jill, which project will the managers choose if they act in the interest of the equity holders?

AppendixLO1