Question 4 (25 marks). This question is about agency conflicts and capital structure.

(a) [4 marks] How can debt financing induce managers to exert higher effort? Explain.

(b) [6 marks] Consider a firm in which the manager has a stake of 100%. The output of the firm depends on the level of managerial effort, e, and is given by Y=10e-e2 units of output. Exerting effort e comes at a linear cost of 3e. Calculate the optimal level of effort and optimal output of the firm.

(c) [7 marks] Consider the same firm as in part (b). Assume now that the firm manager owns only 70% of the firm and 30% is owned by outside shareholders. What is the optimal effort level of the manager and the output of the firm? Explain the intuition for your findings.

(d) [8 marks] XYZ corporation borrowed $70 mln to finance its projects. It currently has two projects with the following payoffs in good and bad states of the economy:

Bad state Project 1 $60 mln Project 2 $20 mln

Good State $100 mln $105 mln

Assume that the good and the bad states of the economy have the same risk-neutral probability of 0.5. Calculate the payoffs to equity holders and debt holders in the good and the bad state. Calculate their expected payoffs. Which project is preferred by equity holders and which is preferred by debt holders?