Question 4 Agency Costs of Debt [8points]

AMCs only asset is a plot of vacant land, and its only liability is debt of $5 million due in one year. If left vacant, AMC will sell the land for $3 million in one year. Alternatively, the firm can build a movie theatre at an upfront total cost of $10 million. The land with a movie theatre on it will be worth $15 million in one year. Suppose the risk-free interest rate is 10%, assume all cash flows are risk-free, and assume there are no taxes.

a) If AMC chooses not to build the theatre, what is the value of the AMCs equity today? What is the value of the debt today?

b) What is the NPV of building the movie theatre?

c) Suppose the firm raises $10 million from equity holders to build a theatre. In that case, what is the value of the firm's equity today? What is the value of the firm's debt today?

d) Given your answer to part (c), would equity holders be willing to provide the $10 million needed to build the movie theatre? Explain.