All agents are risk neutral wealth maximisers

All agents are patient (risk free rate is 0)

One period model with two datesdate 0 and date 1

Managers of a firm have private information about the true state of the firm, j, which is either B (Bad) or G (good)

Firm is currently all-equity financedBefore issuing new shares, the firm has o shares outstanding Firm has access to an investment opportunity

Manager acts to maximise the date 1 payoff of the old shareholders: the shareholders who owned shares before the firm issues debt to finance the project.

The firm has no cash flows at date 0At date 1, its old assets, called assets-in place, that pay aj, j = G,B

If the firm accepts the investment project, its new assets pay I + bj, j=G,B

If the firm accepts the project , it must issue equity to raise I dollars

This involves issuing n new shares at date 0, leaving new shareholders owing the fraction = n/(o + n) of the firm and old shareholders owning fraction 1 of the firm.

bi >0,i=G, B(+NPVproject)

bB bG &aB aG (Gisreallybetter)

Only the mgr. knows whether j = B or G (asymmetric information)

Before observing the firms action, outsiders assign the probability of p to the event that the state j = G

p=Prob. that firm is typeG=Prob. Firm is type B=1/2 Assets in place G: aG = 4.875, Assets in place B: aB = 0.875

Project NPV(sameforGandB): bG =bB =b=0.125

Required investment: I = 1.00

Consider the example of the Myers/Majluf problem. In this example, we found one equilibrium. Suppose that, in this example the firm has o = 5 shares outstanding, (before it issues any new equity).

a. How many new shares, n, will the firm issue when the manager knows the state j = B?

b. What will the price of the shares equal after the manager announces that the firm is going to undertake the project and issue equity?

c. What will the price of the shares equal if the manager announces that the firm will not issue equity and therefore reject the project?

d. What will be the price of the shares right before the manager announces his decision?