The firm Kito expects cash flows in one years time of $90 million if the economy is in a good state or $40 million if it is in a bad state. Both states are equally likely. The firm also has a debt with face value $65 million due in one year. Kito is considering a new project that would require an investment of $30 million today and would result in cash flow in one years time of $47 million in the good state of the economy or $32 million in the bad state. Investors are all risk-neutral and the risk free rate is zero.

(a) What are the expected values of the firm's equity and debt without the new project?

Kito can finance the project by issuing new debt of $30 million. If the firm goes bankrupt the new debt will have a lower priority for repayment than the firms existing debt.

(b) If the new project is accepted, what will be the value of the firms cash flow in each state after paying the original debtholders? What payment must Kito promise to the new debtholders in the good state of the economy?

(c) What will be the expected value of Kito's equity? Will Kito's managers choose to accept the project? Why/why not?

Alternatively, Kito can issue new equity of $30 million to finance the project.

(d) What proportion of its equity must Kito give to the new equity holders? Will Kito's managers choose to accept the project now? Why/why not?

(e) Briefly discuss the agency problem of debt overhang with reference to your answers to the previous parts of the question. (120 words)