The assets in place of companies A and B will generate the following cash flows at the end of the year.

State of the economy	Probability	Cash flows of Company A	Cash flows of Company B
Good	0.4	120	25
Bad	0.6	40	45

After that, the companies cease to exist.

Company A has an outstanding debt with a face value of 70 to be paid at the end of the year. Company B has an outstanding debt with a face value of 30 that is also to be paid at the end of the year. In case of default, company A would incur legal costs of 15. It is assumed that everyone is risk-neutral and the discount rate is zero.

1. Find the value of debt and the value of equity of company A and company B.

[10 marks]

2. Company A considers a merger with company B. The merger would generate a synergy of 10 independently of the state of the economy. In case of default, the merged company would incur legal costs of 15. Explain whether or not a manager acting in the best interest of equity-holders should undertake the merger.

Discuss your answer. [16 marks]