An entrepreneur has access to two mutually exclusive investment projects (project A and project B). Both projects cost $
Posted: Tue Jan 18, 2022 1:01 pm
An entrepreneur has access to two mutually exclusive investment
projects (project A and project B). Both projects cost $60 million
today. One year from now Project A generates a cash flow of $90
million for sure; the cash flow of project B can be $150 million if
the state of the economy is good and $10 million if the state of
the economy is bad. Each state is equally likely. Assume that all
agents in the economy are risk neutral and discount cash flows with
a zero interest rate.
a) Find the net present value (NPV) of each project.
[2 marks]
b) Suppose that the project is fully financed with debt. The
lenders anticipate that in this case the entrepreneur (who is the
unique equity-holder) will prefer to undertake project B. Determine
the face value of their debt and show that project B will indeed be
chosen by the entrepreneur. Compute the value of equity. Discuss
your results.
[10 marks]
c) Briefly discuss how the company could mitigate the problem
arising in question 5b.
[5 marks]
d) Now assume that the project is financed with a mix of the
entrepreneur’s own funds and debt. Assume that the entrepreneur
uses $45 million of her own funds and raises $15 million of debt.
Which of the two projects (A or B) would be undertaken in this
case? Compare your findings with question (b) and discuss your
results.
projects (project A and project B). Both projects cost $60 million
today. One year from now Project A generates a cash flow of $90
million for sure; the cash flow of project B can be $150 million if
the state of the economy is good and $10 million if the state of
the economy is bad. Each state is equally likely. Assume that all
agents in the economy are risk neutral and discount cash flows with
a zero interest rate.
a) Find the net present value (NPV) of each project.
[2 marks]
b) Suppose that the project is fully financed with debt. The
lenders anticipate that in this case the entrepreneur (who is the
unique equity-holder) will prefer to undertake project B. Determine
the face value of their debt and show that project B will indeed be
chosen by the entrepreneur. Compute the value of equity. Discuss
your results.
[10 marks]
c) Briefly discuss how the company could mitigate the problem
arising in question 5b.
[5 marks]
d) Now assume that the project is financed with a mix of the
entrepreneur’s own funds and debt. Assume that the entrepreneur
uses $45 million of her own funds and raises $15 million of debt.
Which of the two projects (A or B) would be undertaken in this
case? Compare your findings with question (b) and discuss your
results.