ABC, Inc. is about to launch a new product. The firm can use either a proven technology or a new (experimental) method. The proven technology will produce a certain cash flow of $24M. In contrast, the cash flow from the new technology are uncertain. If the new technology works, it will produce a cash flow of $28M next year. If it is unsuccessful, it will produce a zero cash flow next year. The probability of success is 0.8 and is uncorrelated with the market return. Both methods require a $20M dollar investment today. There are no cash flows after next year. The risk-free rate is 10%.

a) Explain why we should use the risk-free rate to discount the cash flows from the old technology. Explain why we should use the risk-free rate to discount the cash flows from the new technology.

b) What is the NPV of using the old technology? What is the NPV of using the new technology? Which technology should an all equity firm choose?

c) ABC Inc. has decided to raise $20M by issuing zero-coupon debt due next year. The bondholders believe ABCs assertion that they will use the old technology. (You could also assume that the bondholders have never heard about the new technology). What should be the face value of this debt (i.e., how much ABC should promise to pay to debtholders next year)?