The firm Parke is entirely funded by equity, and the market expects a cash flow of $90$

million in one year from the firms existing projects. Parke is considering a new project

that requires an investment of $40$ million of outside equity now, and will pay a cash

flow in one year of either $50$ million $($probability $0\mathrm{.}5)$ or $35$ million $($probability $0\mathrm{.}5).$

Assume a discount rate of zero and that Parke raises $40$ million now to finance the

investment in the new project.

$($a$)$ Assume there is no information asymmetry between the managers of Parke and

all potential investors. What fraction of equity must Parke offer to new investors?

What will be the expected payoff from the project to the original shareholders?

$($b$)$ Assume now that there is information asymmetry between the managers of

Parke and all potential investors. The market values the cash flow in one year

from the firms existing projects at $90$ million. What will be the payoff from the

new project to Parkes original shareholders, if the managers know that cash

flow from the existing projects will be

$($i$)100$ million;

$($ii$)80$ million?

In each case, state whether the project will be accepted by Parkes managers,

assuming they wish to maximise the payoff to the existing shareholders.

$($c$)$ Considering your answers to part $($b$),$ what will the market infer if Parke issues

equity to finance its new project?

$($d$)$ According to pecking order theory, what stock price responses are expected

to issues of riskless debt, risky debt, and equity, and why?

$($e$)$ To what extent does empirical evidence support pecking order theory?