(30 points) SBUXs competitor YUM has the following cashflows from its existing assets -- $100 in year 1 and either $100 or $60 in year 2 with equal probabilities. It has debt outstanding of $160 coming due in year 1 and $80 in year 2. It has access to two different projects which represent a gift from an unnamed individual. However, it cannot obtain both projects; it has to choose between project 1 or project 2. Project 1 yields $60 in year 1 and nothing in year 2, whereas project 2 yields $85 in year 2 and nothing in year 1. If necessary, YUM is able to issue a bond in the marketplace. All decisions are taken by YUMs managers to maximize the wealth of its stockholders. The required rate of return in this world is 16.67% for all investors (bondholder and stockholders there is no risk premium).

	Year 1	Year 2
		Good state	Bad state
Cashflow from Existing Assets	100	120	40
Debt outstanding	160	80	80
Project 1	60	0	0
Project 2	0	85	85

The cash flows from projects 1 and 2 are: the present values (as of the end of year 1) of The cash flows from projects 1 and 2 are:

Present value of project 1 = $51.28

Present value of project 2 = $72.12

the beginning of year 1 Present value of project 1 = $60

Present value of project 2 = $70.31

Question:

1. If project 1 is chosen, what is the value of the firm (debt plus equity) as of the end of year 1? What is the value of the equity as of the end of year 1?

2. If project 2 is chosen, what is the value of the firm (debt plus equity) as of the end of year 1? (Hint: If project 2 is chosen, how much will have to be raised in new debt to pay off the debt coming due in year 1? What is the rate of return that YUM will have to promise to pay the new bondholders in order to be able to raise the necessary funds? How much will be left over for equityholders?)

3. Which project will equityholders choose? Explain the role of debt overhang.