Consider an unlevered firm that has two mutually exclusive projects available. Both projects last for one year and generate the following cash flows at t=1: Cash flows State of economy Probability Project A Project B Bad 0.2 2400 1200 Medium 0.3 3200 2700 Good 0.5 4000 4500 Both projects require an initial investment outlay of 2500 that can be financed with retained earnings. The risk-free rate of interest is 0% for all maturities and investors are risk-neutral; the state of the economy is only known at t=1.

A levered company also has access to the two mutually exclusive projects A and B, but it has no internal funds available to finance either of the projects. Rather, the company expects that a bank will grant a loan for 2500 that has to be paid back after one year, including a 12% promised interest coupon. This levered company already has an existing debt obligation; at t=1, the total payment due on that debt (both interest and redemption) shall be 4000. Said new bank loan will be subordinated to the companys existing debt. The levered company also has assets in place that will deliver cash flows only at t=1: 3000 in the bad state, 4000 in the medium state, and 5000 in the good state of the economy.

2. (6 points) Which project do the equity holders of the levered company prefer?