You work for Iris Kitall, the CEO and sole owner of Titanic Inc., a young cosmetics company. Titanic currently has no signicant assets in place. If it undertakes a project that requires an investment of $600 today (date 0) it is equally likely to have pre-tax earnings of $1100 or $300 at the beginning of year 1. At that date, Titanic will also have a second project that costs $200 and will yield an additional $400 by the end of year 1. After this date, Titanic will cease to exist. You have been asked to advice Ms. Iris Kitall on Titanics optimal nancing plan. Assume the following. All risk is unsystematic and the risk-free rate is zero (i.e., ignore discounting). Capital markets are e cient and competitive so that new investors need to break-even in order to be willing to supply capital. The corporate tax rate is 20%. All debt payments (interest plus principal) can be deducted for tax purposes. There are no direct costs of bankruptcy. In the event of default no taxes are paid by anyone, debt holders take possession of assets and equity holders get nothing. If Titanic invests in the second project it does so by using its earnings from the rst project.

3(a) Suppose Titanic decides on a conservative capital structure with 100% equity nancing. Find the value of Titanic and the value of old equity (= Iris Kitalls claims).

3(b) Suppose Titanic decides on a leveraged capital structure and raises the outlay for the rst project via a secured debt issue that requires a payment of F (in interest plus principal) due at the end of year 1. If Titanic cannot make the debt payment, it goes bankrupt. You are aware that such levels of debt nancing may lead to debt overhang and underinvestment. Determine the value of F and the total enterprise value of Titanic under this nancing plan. Find also the market value of its debt and equity.

3(c) Consider the plan of raising 50% of the cost of the rst project via a debt issue and the remaining via an equity issue. Assume that when equity is indierent between underinvesting or not, it does not underinvest. Under these assumptions, is this plan better for Ms. Kitall than the 100% debt nancing plan? Is it the optimal nancing plan? Explain your answer.

3(d) Suppose that Titanic can hedge the risk in its rst project in a way that can be veried by its creditors. Hedging transforms the risky cash ows from the rst project into riskfree cash ows equal to $700, the expected value of cash ows from the rst project. Will such hedging alter Titanics unlevered value? Will such hedging aect Titanics debt capacity? What is Titanics optimal nancing plan and shareholder value, assuming hedging? Explain your answer.