1. CASE 1 (40 points)
2. Firms ABC and XYZ are identical, except that ABC is more levered. Both firms will remain in business for one more year. It appears that the probability of the continuation of expansion is 75% for the next year and the probability of recession is 25%. If the expansion continues both firms will generate an EBIT of $1 million. If a recession occurs, each firm will generate EBIT of $400'000. ABC's debt obligation requires the firm to pay $350'000 at the end of the year. XYZ's debt obligation require the firm to pay $500'000 at the end of the year. Neither firms pay taxes. Assume a discount rate of 15%.

Instructions:

a. What are the potential pay-offs in one year to ABC shareholders and bondholders ? What about those for XYZ's ? (10 points)

b. Clearly describe the four different theories explaining how do firms establish their capital structures and explain in few words the underlying assumptions (30 points)