Effect of taxes on Myers and Majluf problem of dilution:

Firm can be of two types - G(ood) or B(ad). NPV of investment opportunity same for both types and equals 8. Required investment to undertake the project is 100; Both types are equally likely; value of type G's assets in place is 125 while value of type B's assets in place is 100.

a) Assuming tax rate = 0, determine whether an equilibrium exists when the firm undertakes the project when it is type G.

b) Assuming tax rate = 50%, redo part a.

c) Depending on your answer in parts a and b, in the general Myers and Majluf setting (without using given numbers) either i) show corporate taxes have no impact on the underinvestment problem or ii) find an alternative tax regime under which the level of taxation will not affect the underinvestment problem.