Suppose you are an investor seeking to find new opportunities to invest. You have identified

two firms: L1 Corporation and BT Enterprises. L1 Corporation is debt free, while BT

Enterprises is highly leveraged. Each firm is run by a manager/entrepreneur, who can exert

two levels of effort: high or low. The project undertaken by the manager of each firm yields

either a high return Rs > 0 or a low return Rf >or= 0, with Rf < Rs. High effort by the

manager increases the probability that the firm realizes a high return.

(a) Suppose there are perfect capital markets, no taxes, and no bankruptcy. Suppose also

that you (and other outside investors) can perfectly observe the effort exerted by the

managers of the two firms, and you can write a contract specifying the effort you want

the managers to exert. Does the amount of leverage of each firm affect its market value?

Explain your answer. (30% of the marks)

(b) Suppose now you and other outside investors cannot observe the effort exerted by the

managers of the two firms. The project undertaken by the manager of each firm yields

either a high return Rs > 0 or a low return Rf = 0. Does the amount of leverage

of each firm affect its market value? If yes, is there an optimal amount of debt to be

issued? Explain your answer. (30% of the marks)

(c) Let us continue with the framework described in point (b) above. Suppose Rf > 0,

with with Rf < Rs. Does the amount of leverage of each firm affect its market value?

If yes, is there an optimal amount of debt to be issued? Explain your answer. (40% of

the marks)

BEEM117