A firm is considering financing a risky project. The project costs $10 million to undertake. The project will either succeed or fail. If the project succeeds it will be worth $15 million to the firm. This happens with probability 0.75. If the project fails, the firm can sell it will be worth only $8.5 million. This happens with probability 0.25. The firm pays corporate taxes of 25%. The tax rate on interest income is 35% and the tax rate on dividend income is 30%. Assume for simplicity that losses cannot be carried forward or used to offset other taxes of investors.

Assume no bankruptcy costs.

Suppose that the firm is financed using $8.5 million in debt and $1.5 million in equity. The firm can choose either the above project or an alternative project that also costs $10 million. The alternative project pays out $15.1 million if it succeeds and 0 otherwise. The probability of succeeding and failing for the alternative project are the same the first project.

1 Which project is better for the firm as a whole?

2 Which project is better from equities point of view? Show your workings