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3. Assume in a company there is debt with a face value of 30, and that investors must agree to choose between one of two projects. The chosen project will generate the following rents one year later: Project A (safe) Project B (risky) Rents, one year later 80 120 with prob. 30% 20 with prob. 70% a) What is the expected value of each project, and which one maximizes de value of the firm? b) Which project do creditors prefer? And which one do shareholders prefer? Is there a conflict of interests between the two? c) Suppose now that the face value of debt is 70. Answer question b) again. d) If you were the social planner, to whom would you like to allocate the decision rights in the company? Is this what happens in reality? What do governments and/or investors do in order to avoid this type of conflicts of interest? NOTE: This is an exercise to illustrate the conflicts of interest between creditors and shareholders. This is a well-known problem in corporate finance called the risk-shifting problem, where shareholders prefer to take on more risk the more debt there is in the company. 3. Assume in a company there is debt with a face value of 30, and that investors must agree to choose between one of two projects. The chosen project will generate the following rents one year later: Project A (safe) Project B (risky) Rents, one year later 80 120 with prob. 30% 20 with prob. 70% a) What is the expected value of each project, and which one maximizes de value of the firm? b) Which project do creditors prefer? And which one do shareholders prefer? Is there a conflict of interests between the two? c) Suppose now that the face value of debt is 70. Answer question b) again. d) If you were the social planner, to whom would you like to allocate the decision rights in the company? Is this what happens in reality? What do governments and/or investors do in order to avoid this type of conflicts of interest? NOTE: This is an exercise to illustrate the conflicts of interest between creditors and shareholders. This is a well-known problem in corporate finance called the risk-shifting problem, where shareholders prefer to take on more risk the more debt there is in the company
