Consider a firm with assets worth $18.18M. The firm has outstanding debt of $24M due in one year. The firm can expand at a cost of $12M million payable now. The estimated market value of the firm following the expansion will equal $36M in one year. Suppose that the risk free rate is 10%.

i. If the firm chooses not to expand, what is the value of the firm?s equity today? What is the value of its debt today? (Assume that there are no other projects that the firm can undertake so the asset value will be $20M if no investment is made.) (3 marks)

ii. What is the net present value (NPV) of the considered capacity expansion? (3 marks)

Suppose the firm considers raising $12M from equityholders to finance the expansion.

iii.Calculate the value of the firm?s equity and debt today if the expansion was decided upon. Would equityholders be willing to provide $12M necessary to finance the expansion in the first place? Explain. (5 marks)

Assume that the creditors are willing to (unconditionally) reduce the face value of debt to $16M.

iv. Would it be optimal for equityholders to invest in the expansion project in such a case? (4 marks)

Now, ignore the option to increase capacity. Assume that equityholders have an option to increase the riskiness of the firm?s operations so that its estimated value in one year equals either $28M or zero, with both scenarios occurring with equal probabilities.

v. Would equityholders decide to increase the firm?s riskiness? Discuss how the level of debt affects equityholders? propensity to increase the riskiness of the firm?s operations. (4 marks)

vi. How will the decision taken in the previous point affect the expected value of the firm as a whole in one year? (4 marks)