Consider a firm that from a previous investment expects to generate an income of 700 with probability 1/2 and 250 with probability 1/2. The firm has 400 debt outstanding (to be paid back at Time 2). After the income of the firm is realized, and before the debt is due, the firm is presented with a riskfree investment project: investing 550 yields 750 in return

Required

1. Determine the shareholders wealth at the end of Time 2 in all possible scenarios
2. Identify whether the firm is affected by the underinvestment issue and discuss, in general, how risk management can help avoid the underinvestment problem