A startup needs to spend $100 in year 0 to build a factory to produce a new electric car. If it builds the factory, it will be able to sell its cars in year 2 if it spends an additional $100 in year 1 on advertising. Otherwise, it will be unable to sell its cars, and its future cash flow in year 2 will be

$0. The companys car could turn out to be a lemon or a peach, each with 50% probability. If the car is a lemon and the company markets it, the company will receive cash flow of $150 in year 2. If the car is a peach and the company markets it, the company will receive cash flow of $350 in year 2. The company has no other assets and can only raise capital to finance the factory by issuing senior debt to be paid off in year 2 and to finance the marketing by issuing junior debt to be paid off in year 2. The company can only raise financing for marketing after the factory is built (i.e., in year 1). Junior creditors financing marketing in year 1 would be different lenders than senior creditors financing the factory in year 0. No renegotiation of debt is possible. Assume no discounting, no taxes, no direct bankruptcy costs, and no information asymmetry.

a) Suppose that the quality of the companys cars (whether they are lemons or peaches) is observed in year 1 (by everybody) before the company raises capital to market the car. Will the company be able to raise capital to market the car if the car is a peach? Will the company be able to raise capital to market the car if the car is a lemon? Will the company be able to finance the factory in year 0? If so, what will the face value of the debt issued in year 0 be?

b) Now, suppose that nobody knows the quality of the car until after the car is marketed. Will the company be able to raise capital to market the car in year 1? If so, what will the face value of the debt issued in year 1 be? Will the company be able to finance the factory in year 0? If so, what will the face value of the debt issued in year 0 be?

Hint: Start by assuming that creditors financing the factory believe that the company will be able to raise capital to market the car and that they price the companys debt accordingly. In the end, you will need to determine whether this belief is correct.

c) Continue to suppose, as in part b, that nobody knows the quality of the car until after the car is marketed. However, now suppose that the company can market the car using one of two mutually exclusive approaches, each of which requires spending $100 in year 1. It can market the car through TV advertising, which will yield cash flow in year 2 of $350 if the car is a peach and $150 if the car is a lemon, as above. Alternatively, it can market the car through online advertising, which will yield cash flow in year 2 of $360 if the car is a peach and $20 if the car is a lemon. The company cannot commit to an advertising approach before it raises capital to finance the advertising. Will the company be able to finance the factory in year 0?