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Problem: Renegotlatlcn and Debt Over-hang Consider a rm with a riskneutral entrepreneur that has assets in place and debt with face value K = 110, due at date t = 1. The assets in place generate at t = 1 a random, veriable cash ow X E {90,130} with Pr(X = 90) = Pr(X = 130) = %. In addition, the rm has an investment opportunity. The investment requires an outlay F = 10 at date t = I] and generates an additional return Y with certainty at date t = 1. There is no discounting (all risk is diversiable and the riskfree rate is zero). Finally, the entrepreneur is protected by limited liability and has personal wealth W b F that is not invested in the rm and may thus be used to nance the investment outlay F. 1. Suppose that the new investment can be undertaken as a separate project, e.g., the entrepreneur can set up a new rm which carries out the investment project. State the condition under which the project is undertaken. 2. From now on assume that the project has to be undertaken inside the existing rm, i.e., that the cash ow of the investment cannot be separated from that of the assets in place. State the condition(s) under which the project is undertaken in the absence of renegotiation. Explain. 3. From now on assume that Y E (10, 20). Suppose that the initial ace value of debt K can be renegotiated prior to the investment decision. Assume also that the new face value K ' is conditional on the investment taking place. That is, the investment decision is veriable, and the initial face value of debt is valid if the investment is not undertaken. Show (by example) that successful renegotiation and debt forgiven- K " K can be Paretoimproving (that is, a scenario can be Paretoimproving if and only ifsome agent (5) can be made strictly better o without making any agent worse oil"). 4. Can renegotiation restore rstbest incentives (that is, we are in the rstbest sce nario if and only if all investment projects with a positive N'PV are undertaken)? 5. In contrast to 3. and 4. assume that the investment decision is not veriable and hence the debt reduction offer K K" cannot be made conditional on the investment taking place. That is, the creditor rst makes an o'er K ', the owner-manager acceptsfrejects and then decides whether or not to invest. Assume further that the creditor has all the bargaining power in the renegotiation, i.e., makes a talceitor leaveit offer with face value K '. State the condition(s) under which the project is undertaken. Explain