A start-up firm needs $100 million to launch its product. It has already signed a contract to provide its services to one major customer, this will result in $5 million in profits annually in perpetuity, starting this year. There is a 50 per cent chance the firm will sign a contract with a second customer with expected profits of $15 million in annual profits. If this deal is not signed, the firm only has $5 million in profits. The corporate tax is 15 per cent. In case of bankruptcy, 40 per cent of firm value is lost. Everyone is risk neutral with a 10 per cent discount rate.

a. Suppose the start-up funds the $100 million through equity. What share of equity must be offered to outside investors? What is the present value of the initial investors’ stake.

b. Suppose the start-up funds the $100 million through debt (perpetuity). What coupon payment must be offered to creditors? What is the present value of the initial investors’ stake.

c. Suppose the start-up funds half of the $100 million through debt and the rest through equity. What coupon payment must be offered to creditors? What share of equity must be offered to outside investors? What is the present value of the initial investors’  stake. What is the best way to finance this project? Comment on trade-off theory.

d. Suppose there were no bankruptcy costs. What would be the optimal choice of financing