16.4. Hiroko Fashion Corporation (HFC) can pursue either project Dress or project Cosmetic, with possible payoffs at year-end as follows:

Each project costs $6 million at the beginning of the year. Assume there are no taxes, there are no direct bankruptcy costs, all investors are risk neutral, and the risk-free interest rate is zero.

a. Which project should HFC pursue if it is all equity financed? Why?

b. If HFC has a $5 million bond obligation at the end of the year, which project would its equity holders want to pursue? Why?

Bad Economy Good Economy

(prob.  30%) (prob.  70%)

(in $ millions) (in $ millions)

Project Dress $2 $9 Project Cosmetic 7 6