Consider an economy with three dates {t=0, 1, 2}. A firm has assets in place that generate an output (profit) of either 40 in state L or 180 in state H at t=2. Both states equally likely. At t=1, the firm can implement another project. The implementation costs are 110 and the new project delivers an output of 120 in state L and 130 in state H at t=2. The owner of the firm and investors are risk neutral. They maximize their expected payoff. The risk free rate is r=0. The firm wants to issue equity to finance the new project.

(a) What is the value of the firm (i) without and (ii) with the project at t=0?

(b) What percentage of equity does the firm sell to raise the investment cost at t=1?

Now suppose prior to issuing equity the firm learns the true state of t=2 at t=1.

(c) Does the firm issue equity in both states?

(d) What is the value of the firm if equity is issued?