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A firm has 1 0 0 m in cash on hand and a debt obligation of 1 0 0 m due next period. With this
A firm has m in cash on hand and a debt obligation of m due next period. With this cash, it can take one of two projects A and B which cost m each. Assume that the firm cannot raise any additional funds. If the economy is favourable, project A will pay m and project B will pay m If the economy is unfavourable, project A will pay m and project B will pay m Assume
that investors are riskneutral, there are no taxes or direct costs of bankruptcy, the riskfree rate of interest is nil, and the probability of each state of nature obtaining is equal.
a What is the NPV of each project?
b Which project will equityholders want the firms manager to take?
c Show that debtholders would find it incentivecompatible to cut the face value of their claim to m
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