Dany Ekwood has two mutually exclusive start-up ideas that require the same investment of $75 thousand at time t = 0. The first idea is an audio streaming service that will generate at time t=2 a cash flow of $120 thousand with probability 0.6 or a cash flow of $50 thousand with probability 0.4. The second idea is a platform for digital audio books that will generate at time t = 2 a cash flow of $140 thousand with probability 0.4 or a cash flow of $10 thousand with a probability of 0.6. Dany has no money to invest in his ideas and must raise all the funds externally. The risk-free rate is zero and all agents are risk-neutral.

a) Find the net present value (NPV) of each project. [2 marks]

b) Dany approaches a bank to raise all the funds needed. The bank believes that Dany will invest in the audio streaming platform.

i) What is the face value of the banks debt?

ii) Which of the two projects will Dany choose to undertake?

iii) Discuss your findings.

[8 marks]

c) Assume that the bank continues to believe that Dany will invest in the audio streaming platform. What is the maximum value for the face value of debt for which Dany will indeed prefer to invest in the audio streaming platform. Discuss your result. [4 marks]

Assume that at time zero Dany finances the audio streaming platform with a mix of debt and equity. The face value of the outstanding debt that will mature at time t=2 is $75 thousand. At time t=1 Dany has the possibility to invest in a podcast production division. The new division requires an investment of $25 thousand at t=1 and will generate a cash flow of $30 thousand at time t=2.

d) Would the existing equity-holders of the company be willing to finance the investment in the podcast production division? Explain your result. [6 marks]

e) Dany considers the option of raising the funds needed for the investment in the podcast development division by issuing debt with lower seniority than the existing debt but decides that it will not be in the interest of the existing equity-holders to do so. Illustrate how Dany may have come to this conclusion. [5 marks]