Case 1: Capital structure. Novapharm must choose one of three different investment strategies. The payoffs (after-tax) and their likelihood for each strategy are shown below. The risk of each project is diversifiable.

Strategy Probability Pay-off

A 90% 180

10% 30

B 50% 320

50% 0

C 20% 550

80% 50

a. Which project has the highest expected payoff?

b. Suppose Novapharm has debt of $100 million due at the time of the projects payoff. Which project has the highest expected payoff for equity holders?

c. Suppose Novapharm has debt of $250 million due at the time of the projects payoff. Which project has the highest expected payoff for equity holders?

d. If management chooses the strategy that maximizes the payoff to equity holders, what is the expected agency cost to the firm from having $100 million in debt due?

e. What is the expected agency cost to the firm from having $250 million in debt due?

f. From a theoretical perspective, what is the market imperfection that generates the agency costs highlighted in the previous questions?