Consider a firm whose value in the next period depends on the state of the economy.

	Recession (prob=0.5)	Expansion (prob=0.5)
Cash flow	40	120

The firm has debt outstanding with a face value of $60. Assume that the required rate of return is zero (i.e., no discounting).

a. What is the market value of debt?

b. What is the market value of equity?

Suppose that the company will invest in a zero NPV but risky project. In particular assume that if the firm invests an additional $15 today it will receive $30 in expansion but $0 in recession. Suppose the firm raises the $15 by issuing debt that has the same seniority as the existing debt.

c. What is the face value of the new debt?

d. What is the market value of the old debt after the new project is undertaken?

e. What is the market value of the equity after the new project is undertaken?

f. Do shareholders want to accept the project?

A. Yes, because shareholders can extract some value of the new debtholders by undertaking the risky project.

B. Yes, because shareholders can extract some value of the old debtholders by undertaking the risky project.

C. No, because the project has zero NPV.

D. No, because issuing more debt increases the probability of bankruptcy.