Company X has an investment project requiring a $10m investment today and that has a

$1m net present value. The company has 1 million shares, no internal funds and, given the

nature of its business, cannot get debt financing. Hence it must raise funds by issuing equity

or abandon the project. While the market knows all about the investment project, it does

not know whether the value of the companys existing assets (i.e., excluding the new

project) is $10m or $2m and regards both values as equally likely. Management knows the

assets value and investors are aware of that. Therefore, management must consider

investors (and hence the stock prices) reaction to the announcement of an equity issue. A

priori, three scenarios are possible:

Scenario 1: Investors would infer nothing about the assets value.

Scenario 2: Investors would infer the assets value is $2m.

Scenario 3: Investors would infer the assets value is $10m.

a. For each scenario, at what price would the company be able to issue shares?

b. For each scenario, if managers knew the value was $2m, would they go ahead

with the equity issuance or abandon the project?

c. For each scenario, given managers know the value is $10m, would they proceed

with the equity issuance or abandon the project?

d. Show that only one of the three scenarios is possible if investors react rationally.

e. In that scenario, what does the company do? Explain briefly

f. Consider the same questions as above but assuming now that the projects NPV is $5m, not

$1m. Is the outcome (i.e., the answer to question f) different or the same? Explain briefly.