Incentive Structure (25 pt)

On 1/1/2019, Firm XYZ signs a debt contract. According to the debt contract, Firm XYZ raises $100,000 from an investor and promises to pay the investor $100,000 on 1/1/2020 (i.e., the interest rate is zero). On 1/2/2019, Firm XYZ finds that there are two investment opportunities, and each project costs the firm $100,000:

Project 1: $400,000 with probability 0.4 and $0 with probability 0.6

Project 2: $200,000 with probability 1.

i) Which project exhibits a higher NPV? (4 pt)

ii) Which project does the firm prefer? (7 pt) Firm prefers project 1 because

iii) How about debtholders? (7 pt) Debtholders would prefer project 2 because

iv) Suppose that, on 1/1/2019, the investor knows that the firm will choose a project between project 1 and 2. Would the investor choose to sign the debt contract? (7 pt)