Charles, the CEO of an engineering firm, can invest $8 million in a project that will give a single cash inflow of $17 million in one year if Charles chooses to devote his full effort to the project (work). Charless utility from the project is the payoff he receives from its cash flow. He has a hobby restoring vintage cars and can choose to spend part of his time on this relaxing activity instead of the project (shirk). If he does this, the project will give a single cash inflow of $12 million in one year. Charless disutility from giving up his hobby to give his full effort to the project is $3m.

Assume Charles has no personal wealth and the project should be financed entirely by outside investors. Charles, and every potential investor in Charless project, is risk-neutral. The discount rate is zero.

1. Suppose James finances the project with outside equity, and the investors believe he will choose to work.

(i) What proportion of equity will they demand? What will be the utility for Charles if he chooses to work?

(ii) Assume Charles can choose how much effort he uses for the project after the finance has been raised. What will his utility be, if he chooses to shirk?

2. Assume now the investors are aware of Jamess hobby. What proportion of equity will they demand? What will Charless utility be if he chooses to shirk?

3. Suppose Charles can finance the project with debt. What will be the face value of the debt? What will Charless utility be, if he chooses to work? What will it be if he chooses to shirk?

4. (i) Explain the agency cost of outside equity with reference to your answers to parts (a) to (c) above.

(ii) Suggest and briefly explain a possible solution to this agency problem, apart from the financing choice.