Conflict Between Debt And Equity

Suppose a company has $10 which can be invested into three projects with the following random payoffs next year:

Project 1 Project 2 Project 3

Good $40 (w/ prob 0.2) $12 (w/ prob 0.5) $15 (w/ prob 0.4)

Bad $0 (w/ prob 0.8) $10 (w/ prob 0.5) $8 (w/ prob 0.6)

For simplicity, there is no time discount.

a) Suppose the firm is purely equity financed. How does the firm rank the three projects? Show your work.

b) Suppose the firm carries debt maturing in the next year with face value $10. How does equity holder rank the three projects? How does debt holder rank the three projects? For face value $1, redo the rankings.

c) What is risk shifting problem? Comparing your findings in b) and a), briefly discuss the relation between risk shifting and the face value of debt.