A company is thinking about whether to invest in a new project. The firms market value is $2,000. The face value of debt in the balance sheet is $3,000. The one-year project would have to be financed by equity, and the initial investment costs $2,500. The firms equity will be entirely invested in the project. The remaining $500 of the initial cash outlay will be entirely financed by shareholders. That is, shareholders will invest an additional $500 in the project. The predicted cash flows are $3,500 in a good economy with a 80% probability and $2,000 in a poor economy with a 20% probability. The discount rate for the firm is 15% and the tax rate is zero.

a. What is the expected payoff and NPV to debtholders if project is taken? Would they want the project to be

accepted?

b. What is the expected payoff and NPV to shareholders if the project is taken? Would they want the project

to be accepted?

c. If you assume the firm is all-equity, should the shareholders undertake the project?