Caratinga is a 100% equity company whose only option is to invest either in project A or project B (i.e., it can only invest in A or only invest in B). Each project requires an investment today of 500 million. Next year, project A pays 650 million with probability 75% and 250 million with probability 25%. Next year, project B pays 800 million with probability 25% and 250 million with probability 75%. After these cash flows, the firm will be shut down. There are no taxes, depreciation, or any other benefits. In order to implement one of these projects, the company must raise debt financing. The managers of the company act in the best interest of equityholders. Debtholders can rationally anticipate the actions of managers. Assume all cash flows are discounted at 0%.

Now assume the company has guaranteed contractually that project A is chosen and has arranged the debt financing of 500 million. However, according to the companys legal team a loophole in contract implies that the company would not run into problems if it decides to undertake project B rather than project A. Are managers still undertaking project A or would they prefer to undertake project B? Be precise: show your steps and explain your reasoning. Discuss your findings.