Problem 2 (15 points)

A company has a project that costs $200 million today and pays off either $120 million or $300 million next year, each with 50% probability. The company currently has 1 million shares outstanding, no cash on hand, and no other assets except for this potential project. Assume that there is no discounting, taxation, or direct cost of bankruptcy.

2a) (5 points) Can the company finance this project with a sale of new equity? If so, how many shares would it need to issue?

2b) (5 points) Can the company finance this project with a sale of bonds? If so, what would it need to promise to repay to creditors in order for creditors to fund the project?

2c) (5 points) Suppose now that the company has an alternative, mutually exclusive project that also costs $200 million and pays off $600 million with 20% probability and $80 million with 80% probability. At the time it raises capital, the company cannot make a legally binding commitment to one of the two projects. Will the company be able to raise money by issuing debt to fund one of its projects?

Problem 6 (15 points)

A start-up company with no tangible assets has already invested $50,000 in R&D.It will learn at the end of the year whether the R&D is successful or not.If the R&D is successful (90% probability), the company can then invest in manufacturing.Investing in manufacturing requires spending an additional $53,000.If the R&D is successful and the company invests in manufacturing, then it will receive a cash flow of $153,000 if the economy is an expansion and $61,000 if the economy is in a recession.The economy is in an expansion with 50% probability and in a recession with 50% probability.The company and potential investors observe the state of the economy before the company decides whether or not to invest in manufacturing.If either the R&D effort is unsuccessful or the company does not invest to start manufacturing, then its future cash flows will be $0.The company has no cash, so it will need to raise $53,000 of capital (by issuing debt or equity) next year in order to be able to invest in manufacturing.Assume that there is no discounting, taxation, or direct cost of bankruptcy.

1) What is the company's total value today if it financed the R&D investment with equity?

2) What is its total value if it financed the R&D investment with debt?