4. Suppose there are two kinds of companies, good and bad ones.Both types of companies are faced with an investment opportunity that requires an investment of $6M today (year 0) and can give a high or a low cash flow in year 2, but they differ in the probabilities of the high and the low cash flows as follows:

There are as many good as bad companies around and the discount rate is zero.

Assume that managers (who are also the initial owners of the companies) know whether their company is good or bad in period 0, but investors do not know until year 1 (after the investment is made but before the cash flow uncertainty is resolved ). The companies need to raise capital in year 0.

Managers suffer a huge personal loss if the company goes into financial distress (they die from a stroke). They want to avoid that at any cost. Therefore, they cannot finance the investment with normal debt.

First assume that companies can only raise capital by issuing equity.

a) If all companies issue equity, what proportion of year 2 cash flows will investors demand to finance the $6M investment in year 0?

Probability of cash flow

Cash flow

Good company

Bad company

15$M

0.8

0.2

5$M

0.2

0.8

Now assume that companies can also choose to issueconvertible debtto raise the $6 million. The debt has a face value F = $6M but can be converted into a proportion X of the company's equity in year 1 (afterinvestors have learnt whether companies are good or bad but before year 2 cash flow uncertainty is realized).

To solve questions (b) - (c) below, assume that investors believe in period 0 that a company that issues convertible debt is good, and a company that issues equity is bad. (You will then check whether these beliefs are actually correct.)

1. b)What proportion of year 2 cash flows will investors demand from companies that issue equity to be willing to finance the $6M investment in year 0? What proportion of year 2 cash flows (this is the X from above) will investors demand from companies that issue convertible debt, if we assume that convertible debt holders will convert into equity in year 1?
2. c)Check whether it is actually true that in the situation above, managers of good companies prefer to issue convertible debt, and managers of bad companies prefer to issue equity. (This involves checking the conversion decision of debt holders when they learn whether it is a good or a bad company, and the pay offs to managers depending on their choice of financing. The manager gets what's left in year 2 after paying off debt or new equity, and incurs the huge personal loss if the company goes into financial distress). Explain the intuition.