2. Suppose a company borrows $1 million debt to invest in a project that generates uncertain cash flow (revenue) of 0~$2 million. The debt has to be repaid (interest rate is zero) when the projects cash flow is realized. Clearly mark where the lines start, end and change direction.

2-1. Reconsider the case of strategic default covered in class except lets assume 20% bankruptcy cost (note: in class, we considered 50% bankruptcy cost). That is, Assume 20% of the cash flow (revenue) is lost upon bankruptcy (i.e., when debtholders control the firm). Also, assume that renegotiations are allowed and the manager may be allowed to stay if debtholders find it better than firing. Upon renegotiation debt and equity holders have equal bargaining power. Draw value of debt, equity, and the company.

2-2. For Question2-1, at what company cash flow does strategic default start to occur?

DEBT VALUE EQUITY VALUE COMPANY VALUE 1.5 1.5 1.5 0.5 0.5 0.5 0.5 1.5 0.5 1.5 0.5 1.5 COMPANY REVENUE GMILLON COMPANY REVENUE (SMILLION COMPANY REVENUE (SMILLION) DEBT VALUE EQUITY VALUE COMPANY VALUE 1.5 1.5 1.5 0.5 0.5 0.5 0.5 1.5 0.5 1.5 0.5 1.5 COMPANY REVENUE GMILLON COMPANY REVENUE (SMILLION COMPANY REVENUE (SMILLION)