Abby Incorporated has assets in place that will generate the following state dependent cash flows in one year: $64 million, $150 million and $210 million. The probabilities of realization of each cash flow depends on whether the manager chooses to adopt a safe strategy or a risky strategy. The probabilities are as in Table 1 below. Assume that there are no taxes and the discount rate is zero.

Table 1

Manager adopts safe strategy			Manager adopts risky strategy
Probabilities	Cash Flows		Probabilities	Cash Flows
1/3	$64 million		0.5	$64 million
1/3	$150 million		0	$150 million
1/3	$210 million		0.5	$210 million

1. Find the value of the firm, if the manager adopts the safe strategy and if the manager adopts the risky strategy.

[3 marks]

Assume that the firm has an outstanding debt with face value of $50 million that matures in one year.

2. Assume that the manager acts in the interest of the equity-holders. Find the value of debt and the value of equity under each scenario. Will the manager choose to adopt the safe strategy or the risky strategy?

Discuss your answer.

[7 marks]

Now assume that the firm has an outstanding debt with face value of $115 million that matures in one year.

3. Assume that the manager acts in the interest of the equity-holders. Find the value of debt and the value of equity under each scenario. Will the manager choose to adopt the safe strategy or the risky strategy?

Discuss your answer.

[8 marks]

4. Use your findings at Questions 4b and 4c to discuss the following statement: the high level of debt is at the origin of an agency cost for the firm of 5 million.

[7 marks]