A firm want to raise $30m to invest in a project. After the $30m investment, the rm will

have a total asset value of $100. The risk-free rate is 10%, and the volatility of the return on

assets is 20%.

(a) If the rm wants to issue 10-year debt (zero-coupon), what face value do they need to

set?

(b) Now imagine that the bond has been issued (with a face value that you found in the

previous part), but that the stockholders can choose an action that changes the nature

of the cash ows. Namely, the shareholders can: (1) do nothing, (2) take an action that

will immediately reduce the value of the assets from $100 to $99m and at the same time

raise the volatility to 30%. Will the shareholders take this action?

(c) If the bondholders anticipated this possibility when they were oered to invest in the

company, what do you expect they would have demanded as a face value?

(d) Would the shareholders have an incentive to include a covenant prohibiting the action in

part (b) above?