Question
a) A firm is about to issue debt with a face value of $100. Everybody knows that immediately after the issue it will have to
a) A firm is about to issue debt with a face value of $100. Everybody knows that immediately after the issue it will have to choose between two investment projects. One project will have a 50% chance of ending up with 0 dollars, and 50% chance of $150, whereas the other will have a 70% chance of $100 and 30% of $101. Which project will shareholders choose? Which one will be preferred by bondholders? (please provide a calculation) b) The question below is a bit more challenging: If we assume risk neutrality and a zero interest rate (no discounting) what will be the value of debt the firm can issue, assuming that bondholders are not cheated? c) (unrelated to a and b) A new tax law will equate the tax rates of indviduals on interest income and equity income (capital gains and dividends). If you believe the Miller model, what should all firms in the economy do? Please provide a short paragraph you can prove within the model.
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