2.

James, the CEO of an electronics firm, can invest $8 million in a project that will give a single cash inflow of $17 million in one year if James chooses to devote his full effort to the project (work). Jamess utility from the project is the payoff he receives from its cash flow. He has a hobby restoring vintage cars and can choose to spend part of his time on this relaxing activity instead of the project (shirk). If he does this, the project will give a single cash inflow of $12 million in one year. Jamess disutility from giving up his hobby to give his full effort to the project is $3m.

Assume James has no personal wealth and the project should be financed entirely by outside investors. James, and every potential investor in Jamess project, is risk-neutral. The discount rate is zero.

1. Suppose James finances the project with outside equity, and the investors believe he will choose to work.

(i) What proportion of equity will they demand? What will be the utility for James if he chooses to work? (4 marks)

(ii) Assume James can choose how much effort he uses for the project after the finance has been raised. What will his utility be, if he chooses to shirk? (3 marks)

2. Assume now the investors are aware of Jamess hobby. What proportion of equity will they demand? What will Jamess utility be if he chooses to shirk?

(3 marks)

3. Suppose James can finance the project with debt. What will be the face value of the debt? What will Jamess utility be, if he chooses to work? What will it be if he chooses to shirk? (6 marks)

4. (i) Explain the agency cost of outside equity with reference to your answers to parts (a) to (c) above. (160 words) (6 marks)

(ii) Suggest and briefly explain a possible solution to this agency problem, apart from the financing choice. (3 marks)

(Total = 25 marks)