Consider equity holders choice between two mutually exclusive projects: Project A and Project B. Both have upfront cost at Year 0 of $50 million and equity plans to finance entirely with debt. Cash flows in the year following the investment are partially state-contingent. Project A has a certain cash flow of $60 million regardless of the state of the world in Year 1, but Project B has a

cash flow of $90 in the Good state, and a cash flow of $20 million in the Bad state. The risk- neutral probability of the Good state is 1/2.

Assume that the risk-free rate is 0% and that equity holders are considering the choice of two mutually exclusive debt markets to tap: Nave and Sophisticated. In the Nave market, potential lenders are not aware of agency costs of debt and always believe that equity holders will take actions that maximize firm value regardless of capital structure. In the Sophisticated market,

potential lenders are aware of agency costs of debt and the incentives of equity to engage in ex- post appropriation of wealth from bondholders. In particular, Sophisticated market lenders

understand the risk-shifting incentive of equity that arises from the convexity of their claim in the firms asset volatility.

Answer the following questions: 1. Which project maximizes firm value? 2. Assume equity taps the Nave market a. What promised face value of debt must equity issue to raise the $50 million upfront cost? b. Based on the face value you calculated in (a), calculate the payoff to equity in each project and find which project they will take. c. What is the expected payoff to the Nave investors given the promised face value from (a) and project choice from (b)? 3. Assume equity taps the Sophisticated market a. What promised face value of debt must equity issue to raise the $50 million upfront cost? b. Assume that equity cannot commit to taking a certain project ex-ante. Which project do they select in this case?