Petron Corporation’s management team is meeting to decide on a new corporate strategy. There are four options, each with a different probability of success and total firm value in the event of success, as shown below:

Strategy A B C D Probability of Success 100% 80% 60% 40%

Firm Value if Successful (in $ million) 50 60 70 80 Assume that for each strategy, firm value is zero in the event of failure.

a. Which strategy has the highest expected payoff ?

b. Suppose Petron’s management team will choose the strategy that leads to the highest expected value of Petron’s equity. Which strategy will management choose if Petron currently has i. No debt?

ii. Debt with a face value of $20 million?

iii. Debt with a face value of $40 million?

c. What agency cost of debt is illustrated in your answer to part (b)?

AppendixLO1