You are establishing a new company. You have no money of yours and you can only raise debt to finance your activity. There are 2 mutually exclusive projects (Projects A and B) you can undertake, both require and initial investment of 50. Project As assets will produce in 5 years a cash flow of 60 with probability 0.5; and 50 with probability 0.5. Project Bs assets will produce in 3 years a payoff of 40 with probability 0.8; and a payoff of 100 with probability 0.2. Assume that agents are risk neutral and that the market interest rate is 0. Also, debt holders are competitive, that is, they will only require, in expectation, the market interest rate. Finally assume that the company cannot commit ex-ante (i.e. before issuing debt) to choose one or the other project. a) Which project will be undertaken? Why? [7 Points] b) What is the face value of the debt issued by the company? [7 Points] c) If the firm could commit to choose one project, how richer would the shareholder be compared to the case of no possibility of commitment? Why? [5 Points]

Take into consideration the asset sustitution problem