Mini Case $4\mathrm{.}6$

A company has two investment opportunities, replacing an old production line with new one using

similar technology $($denoted as IO$1)$ and investment in a new production line with risky brand$-$new

technology $($denoted as IO$2).$ The cash flows of each investment opportunity at the end of the year are

as follows:

Each project requires an initial investment of $350.$ The company can only invest in one of the two

projects. All players are risk neutral, the risk$-$free interest rate is $0$ and there are no taxes. Assume that

management acts in the interest of shareholders.

a$.$ Which project yields the highest net present value?

b$.$ Which project does the management choose if the company is $100\%$ equity financed?

Calculate the equity value.

The company finances the investment cost of $350$ by taking out a loan. However, the lending bank

cannot observe which investment opportunity the company chooses after the loan is granted, but

anticipates the shareholders' optimal decision.

c$.$ Which project does the management choose if the project is financed with $350$ debt,

assuming that the firm needs to pay back $350$ by the end of the period?

d$.$ Taking into consideration the possible choice of the management, what is the repayment

requirement of the bank for this $350$ loan?

e$.$ Calculate the value of equity.

f$.$ What agency cost is illustrated in your answers above and how high is the expected agency

cost$?$