Assume that a firm has $100 in assets today. In one year, it will have to repay $100 to bondholders. Also assume that the discount rate is 10%. Also assume that assets are indivisible (e.g., if the firm decides to invest in a project of $90 now, the remaining $10 cannot be used for other purposes. So the firm must invest all or none) but can be liquidated at any time for the full amount. Also assume that the firm can borrow or invest freely at the 10% discount rate and that the debt can be retired at any time for its present value (so it is always an option to liquidate all assets and pay off bondholders at any point in time). Assume that all parties are risk-neutral. The firm has three mutually exclusive investment opportunities as follow:

Project (X): investment required = $90, cash flows = $190 in good economy, $ 0 in bad economy (40% probability for good economy and 60% probability for bad economy)

Project (Y): investment required = $90, cash flows = $140 in good economy, $ 50 in bad economy (50% probability for each state occurring)

Project (Z): investment required = $90, cash flows = $108 in good economy, $90 in bad economy (50% probability for each state occurring)

1. Assume that managers maximize the value of the firm. What will they do? Does this also maximize the value of the equity? Debt? [4]

2. Assume that managers do not act in shareholders interests. Rather, they act in their own interests. Also assume that the management is compensated with 100% equity and are risk averse. For example, they would rather receive $1 with certainty than taking on risk to increase this amount. Now, which course of action will they take? Does this maximize the value of the firm/equity/debt? Explain. No calculations are necessary. [4]

3. Now, assume that the discount rate changes to zero percent. How will your answers to (a) (b) change? Explain. No calculations are necessary. [4]