4. Natural Water Service Co. has two mutually exclusive $50M projects, S and R, which it plans to finance with debt. Project S returns $60M for sure in a year; project R returns $95M in good state but $20M in bad state in a year. The two states are equally likely. Assume risk neutrality and 10% risk-free rate.

1. Whats the optimal investment decision if managers maximize firm value?

b) Suppose Natural Water can raise the $50M by issuing a bond with a face value of $55M from some nave investors. Which project (R or S) will managers choose? Whats the payoff to the (nave) debt holders?

c) With sophisticated lenders, whats the face value of debt, which project is chosen and whats the payoff to equity holders?