The managers of Milton have two possible projects to undertake now, Project P and Project Q. Project P requires investment of 4 million now and will generate certain cash flows of 25 million in one year. Project Q also requires investment of 4 million now and will generate cash flows of either 31 million (probability 50%) or 15 million (probability 50%) in one year. Either Project P or Project Q can be chosen, but not both. Milton has cash now of 4 million which can be used for the initial investment of either Project P or Project Q.

Milton has no other project cash flows. The firm has debt of 20 million which is due for repayment in one year. Milton's managers wish to maximise the wealth of their shareholders.

The discount rate is zero and investors are risk neutral.

(a) For each of the two projects, what will be the expected value of the firm's debt and equity if it is chosen? Which project will Milton's managers choose, and why? (6 marks)

(b) Suppose that Milton's managers can restructure its debt, by using its cash of 4 million to buy back 4 million of the debt now. After this is done, the firm can ask its shareholders for additional equity of 4 million for investment.

What are the expected payoffs of each project to the equityholders and to the debtholders after this strategy, and which project will Milton's managers choose? Will the shareholders agree to provide the additional equity finance? Explain why or why not. (7 marks)

(c) Will Milton's managers choose the debt restructuring strategy in part (b)? Explain why or why not. (5 marks)

(d) Discuss the agency problem illustrated in this case, with reference to your answers to parts (a) to (c) of the question. (maximum of 160 words)

(7 marks)