Assume risk neutrality, a zero risk-free rate, and no taxes.

A producer of luxury goods needs to spend $40K at year 0 to develop a new product. The demand for product is uncertain at year 0. At year 1, however, the producer will learn whether the demand for the product is high (probability 5/11) or low (probability 6/11). To continue operations, and after learning the demand, the producer must decide whether to spend an additional $20K at year 1. If the producer decides to continue operations, the product will generate at year 2 a CF of $110K if demand is high and of $50K if demand is low. Assume that the producer can only raise funds at t=1 by issuing new equity.

A) Assume that the producer intends to finance the original $40K of year 0 by issuing senior debt that matures in year 2. Will the producer be able to do so? If it can, calculate the face value of the senior debt, and the value of equity at t = 0 (right after raising the $40K in senior debt).

B) Assume that in the case of low demand, debt-holders could get together and renegotiate the face value of the debt. If demand is indeed low, will the debt-holders agree to renegotiate their debt? If so, by how much should they reduce the face value of debt?

C) If debt-holders anticipate that they can renegotiate the face value of debt in the case of low demand: (i) Calculate the face value of the debt that the producer must issue at t=0 in order to raise $40K (ii) Calculate the value of equity at t = 0 (right after raising the $40K in senior debt). Very briefly explain why the value of equity is lower or higher than in part (a)?

D) Now assume that in the case of high demand, if the producer spends the additional $20K at year 1, the shareholders can take one of two alternative projects:

• A safe project, that as before, yields a CF of $110K at t =2.
• A risky project that yields a CF of $140K or $0 at t = 2 with equal probability (i.e., 0.5)

The producer plans to finance as much as possible of the initial investment by issuing senior debt and the rest by issuing equity. Up to how much of the initial $40K can the producer finance with senior debt? (Note:In part (d) assume that in the case of low demand renegotiation doesNOTtake place).