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 new risky project. In particular assume that the project requires zero investment today and will generate $10 cash flow in expansion but $-20 in recession

c - What is the NPV of the new project

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?

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

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

III. No, because the project has zero NPV.

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