Company HDH Constructions Inc. faces a new opportunity that needs an investment of 150 million at t=0 and a follow-up investment of 120 million at t=1. The payotts at t=2 depend on the state of the economy (see the table below). Each state has the same probability. The future state of the economy is revealed at t=1, just before the 120 million needs to be invested. In case this follow-up investment is not made, the future payoffs on the project will be zero and the initial investment would need to be written off completely. State Probability Payoffs at t=2 Best 1/3 450 million 1/3 300 million Worst 1/3 150 million Base HDH wants to finance the investment opportunity completely with debt in the form of project financing. The plan of management is that the company raises 150 million of senior debt at t=0, and that is will raise another 120 million of junior debt at t=1. Assume that all investors are risk neutral and have rational expectations (i.e. investors will anticipate others to make optimal decisions). Further assume that there is no time value of money (i.e. the risk-free interest rate is 0%). a. Sometimes a company has so much debt that it is impossible to get new financing for positive NPV projects. What is this problem called in the literature? (2 points) b. What are two possible solutions for this problem? (3 points) Company HDH Constructions Inc. faces a new opportunity that needs an investment of 150 million at t=0 and a follow-up investment of 120 million at t=1. The payotts at t=2 depend on the state of the economy (see the table below). Each state has the same probability. The future state of the economy is revealed at t=1, just before the 120 million needs to be invested. In case this follow-up investment is not made, the future payoffs on the project will be zero and the initial investment would need to be written off completely. State Probability Payoffs at t=2 Best 1/3 450 million 1/3 300 million Worst 1/3 150 million Base HDH wants to finance the investment opportunity completely with debt in the form of project financing. The plan of management is that the company raises 150 million of senior debt at t=0, and that is will raise another 120 million of junior debt at t=1. Assume that all investors are risk neutral and have rational expectations (i.e. investors will anticipate others to make optimal decisions). Further assume that there is no time value of money (i.e. the risk-free interest rate is 0%). a. Sometimes a company has so much debt that it is impossible to get new financing for positive NPV projects. What is this problem called in the literature? (2 points) b. What are two possible solutions for this problem? (3 points)
