You are the sole bondholder in a firm that will be liquidated next year. Your main concern is that you will not be paid back the $100M you are owed at that time. The current market value of the firm is $110M, although it is unknown what the market value will be next year.

a) Provide the payoff diagram for the bondholder with the final market value of the firm on the x-axis.

b) The financial manager of the firm currently has to make a choice between two projects:

Project A: Will cause the market value of the firm to be equal to $100M or $120M next year with equal probability. Project B: Will cause the market value of the firm to be equal to either $200M or nothing next year with equal probability.

Assume that the bondholders and shareholders have to maintain their positions until firm liquidation next year. What is the expected payoff to bondholders and shareholders next year under each project choice? If the manager is acting in the best interests of the shareholders, which project would he choose? Assume this choice is made for the rest of the problem.

c) The financial manager, acting in the shareholders