Firm X, with senior debt in its books with $80 face value, has assets that yield the following

cash flows next period:

$100 with probability = 0.1 (i.e., "good state"), or $20 with probability = 0.9 (i.e., "bad state")

Firm X has the opportunity to invest in a project that requires $6 today and will yield $10

next period with certainty. Firm X has no cash and needs to raise the $6 in additional funds

to invest in this project. Assume that: (i) the risk-free rate is zero, (ii) investors are risk-neutral, and (iii) there are no taxes.

a) What is the NPV of the project? Can the firm issue securities to finance the project? Will

the firm do so? Explain.

b) Assume now that the firm has only $50 of senior debt in its books, (instead of $80 as

assumed before). Can the firm issue securities to finance the project? Will the firm do so?

Explain.

c) Assume again that the firm $80 of senior debt in its books, but now, in addition to the safe

project described above, it also has access to a risky project. The risky project also requires

$6 but it pays $90 in the good state (i.e., in the good state it would increase the firm's cash

flows from $100 to $190) and -$10 in the bad state (i.e., in the bad state it would reduce the

firm's cash flows from $20 to $10). The two projects (the safe and risky projects) are

mutually exclusive, so only one can be chosen. What is the NPV of the risky project? Which

project will the firm choose? Can the firm issue securities to finance it? Please explain