2. Financial distress problem (20p)

A rm has a risk-free safe asset worth 100, and a risky asset that pays 50 in one state L

and 150 in another state H. Each state is equally likely. The rm has discovered a high-

risk project that costs 100 and and pays o 0 in the low state L and 200 in the high state

H. The rm has outstanding debt with face value F = 200. The debt contract matures in

one year, and the discount rate is zero.

(a) Construct the balance sheet without the project.

(b) Construct the balance sheet under the assumption that the project is nanced inter-

nally by liquidating the safe asset. What do you conclude?

(c) Suppose the project is nanced externally with new junior debt. How much face

value must the rm issue to cover the investment cost? What do you conclude?

(d) Mention one important real-world application of the economic principles from the

numerical example.