The TBY Corporation has fallen on hard times. It has debt with face value of $$5$ million

that will come due at the end of the year. It has $$1$ million in cash. It has two projects it

can invest this $$1$ million in$.$ These projects generate the following payoffs just before

the end of the year.

Project A $$10$ million with probability $0\mathrm{.}05$

$$0\mathrm{.}5$ million with probability $0\mathrm{.}95$

Project B $$5\mathrm{.}5$ million with probability $1$

Both bond holders and stock holders are risk neutral and so are only interested in the

expected payoffs on their securities$.$ They discount payoffs at the end of the year by $10$

percent.

$($a$)$ Suppose the TBY Corporation's covenants on its debt prevent it from paying any

dividends while the firm$$s debt is outstanding. What would the equity holders

prefer the firm to do$?$ What would the bond holders prefer the firm to do$?$

Explain why in both cases.

$($b$)$ How would your answer to $($a$)$ be changed if the covenants on the firms' debt

were such that it was prevented from paying dividends while the firm$$s debt was

outstanding except that it could pay out the $$1$ million in cash as dividends?