(14 points) Suppose a firm has debt with a face value of $1M and a maturity of one year. (The debt does not require coupon payments.) The firms current strategy is risky, and there is only a 40% that it will succeed. In the event of success, the firm will have $3M at the end of the year. In the event of failure, the firm will have only $0.5M. Suppose the firm can undertake an alternative strategy that will increase the probability of success from 40% to 50%. The alternative strategy costs $0.3M to undertake, so the firm will have either $2.7M or 0.2M at the end of the year.

a. (5 points) Show that expected value of payments to equity is greater under the alternative strategy. 8

b. (5 points) Do creditors prefer the alternative strategy? Why? 9

c. (2 points) Explain why corporate loan agreements typically have negative covenants that limit firms ability to make investments.

d. (2 points) Why do firms agree to corporate loan agreements that have negative covenants that limit their ability to make investments?