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Question 1: The two formats fighting for supremacy as the next-generation videodisc format are HD-DVD (developed by Toshiba and NEC) and Blu-Ray (developed by Sony). For the rest of this problem consider Sony as being composed of two assets: Playstation 3, in which Sony has already invested and a Blu-ray project in which Sony has not yet invested. Currently the market believes it is equally likely that Blu-ray could be successful (stateS) or fail (state F). The table reports the value of the Playstation 3 assets and the NPV of the Bluray project in each state of the world. Sony's Blu-ray project requires an investment of $75 million independent of the state. Assume that managers try to maximize the wealth of original shareholders.

(State S)(State F)

Blu-ray succeeds(assets-in-place) 130 50

NPV[ Blu-ray project]=PV[Cashflows]-75 15 5

A) To fund their project, Sony must raise $75 million in equity (no bank will lend against such intangible assets). If managers must issue equity prior to knowing which technology is superior, what percentage of the firm must original equityholders give up in exchange for the capital? Round your answer to the nearest percentage.

B) Sony is an all-equity firm. If there had been debt in their capital structure, maturing after all projects are to be completed, would this raise or lower the percent of the equity demanded by the outside investors? Explain briefly. Assume all the other numbers remain unchanged.

C) If Sony's managers knew whether Blu-Ray would be successful but the market did not, would they always raise equity and invest in the Blu- Ray project? Explain completely showing relevant calculations. Assume equity capital can be raised under the terms which you calculated in A).

D) Prior to Sonys management learning about the success of Blu-Ray technology, Bethea & Associates (B&A) approached Sony with an innovative financing proposal. B&A are private equity investors and have offered to invest $75M in Sony equity, if Sony feels the public market is mispricing their equity. As B&A will carefully investigate the value of Sony's assets, assume that the private equity issue will be correctly priced. B&A wants a $7M fee to cover their costs. Should Sony agree to B&As terms?

E) Now suppose that Sonys management is unlikely to know with certainty whether the Blu-Ray technology is a success before they have to invest. However, early technical results will give them imperfect information on the projected success of Blu-Ray technology. If the preliminary tests results are positive, there is a 60% chance that Blu-Ray will succeed (i.e. State S will occur). Ifthe preliminary test results are negative there is a 40% chance that Blu-Ray will succeed. If they do not invest now, they cannot invest later. Assuming we can issue equity at the terms described in part A, should Sonys management sell equity and invest in the Blu-Ray project based on the early technical results? Explain completely.

Question 2: Anchor Gaming, a manufacturer of gambling machines, has a firm value of $100 million and has $40 million of outstanding debt. Initially, there are 1 million shares of common stock outstanding. Anchor Gaming has only two assets: gambling assets with a beta of 1.2 and $10 million cash. Assume a Modigliani-Miller world for parts A-D

(A) Suppose that Anchor Gaming issues $20 million of equity and uses the proceeds to pay down debt. Thus, after the equity issue, $20 million of debt is outstanding.What would be the effect of debt reduction on firm value? Explain.

(B) Suppose that instead of using the $20 million proceeds from the equity issue to pay down debt, Anchor Gaming uses the $20 million to purchase additional gambling assets. Calculate Anchor Gaming's equity beta after the new equity is issued. Assume that the beta on Anchor Gaming debt is 0.20 before and after the new equity is issued.

(C) What is the new expected return on Anchor Gamings equity.

(D) How many shares of stock must Anchor Gaming issue in order to raise $20 million? Assume the $20 million is used to reduce debt from $40 million to $20 million. What will the stock price be after the new equity issue?

(E) Describe the additional information one would need to value the costs and benefits of Anchor Gaming's capital structure choice in a world with corporate taxes and bankruptcy costs and how one would use that information.