2. Company A has $60 million in debt and $40 million in equity (stock). The debt matures in one year and has a 10% interest rate, so the company is promising to pay back $66 million to its debtholders one year from now.

The company is considering two possible investments, each of which will require an upfront cost of $100 million. Each investment will last for one year and the cash flow from each investment depends on the strength of the overall economy. There is a 40% chance that the economy will be weak and 60% chance it will be strong.

Here are the expected cash flows (all dollars are in millions) from the two investments.

Cash flow in one year if Cash flow in one year if Expected

The economy is weak the economy is strong Cash flow

Investment X $80.00 $130.00 $110.00

Investment Y 35.00 160.00 110.00

Assume that if the company doesnt have enough funds to pay off its debtholders one year from now, then Company A will declare bankruptcy. If bankruptcy is declared, the debtholders will receive all available funds and the stockholders will receive nothing.

a) Which project is more risky? Briefly explain why.

b) If the company invest in Investment X. What is the expected cash flow to the firms debtholders? What is the expected payoff to the firms stockholders?

c) If the company invest in Investment Y. What is the expected cash flow to the firms debtholders? What is the expected payoff to the firms stockholders?

d) Would the debtholders prefer that the companys managers select Project X or Project Y? Briefly explain your reason.

e) Explain why the companys managers acting on behalf of the stockholders might select Project Y even though it has greater risk.