1. (a) (4 points) Firm Xs business is not faring too well and the firm is expecting the following cash flows next year:

- Scenario I: $90 with probability 0.1

- Scenario II: $0 with probability 0.9.

If the firm was to declare bankruptcy, the liquidation value of its assets would be equal to $10. The firm has senior debt with face value of $50 on its books. The firm considers a maintenance project that will cost $1 today and add $2 to its liquidation value.

(i) If the firm undertakes the maintenance project, what are the total cash flows to equity owners and creditors in each scenario?

(ii) In order to fund the maintenance project, the firm needs to issue junior debt for $1.What would the face value of the debt have to be?

(iii) Given the required face value from (ii), will the equity holders decide to issue the junior debt and invest? How does their decision affect the value of the senior debt?

(b) (4 points) Firm Y can choose between two projects. Project S pays $60 for certain.Project R pays

- $100 with probability 0.5

- $10 with probability 0.5

.Both projects require initial outlays of $50.

(i) Compute the expectation and the standard deviation of the NPV for each project.

(ii) If debt is used to finance project, what is the required face value, F, of the bond?

(iii) Which project will equity holders choose?(iv) What is the maximum amount of the debt (face value) the firm can take on such that equity owners will optimally choose the safe project?