Assume the market is equally populated by two kinds of firms: ones with profitable and ones with unprofitable internal forecasts. Assume that all firms are equity financed, and that all profitable and unprofitable firms are identical except for profitability. Because of severe information asymmetry, investors cannot distinguish between types. The managers, however, as corporate insiders, know about their own type. The firms' intrinsic values, which are common knowledge, are $150M and $50M for profitable and unprofitable firms, respectively.

a) If the unprofitable firm needs to raise $30M to invest in a project that will payoff $40M next year, how much of the firm' s stake must it sell in order to raise the capital? Assume the project has a beta of 1 and the market is expected to return 10%.  

b) As a CEO of an unprofitable firm in the market, you have to decide whether the firm raises funds via debt financing or equity financing. Choose your preferred financing method and show why your choice is better than the other option.  

Answer rating: 100% (QA)

a To raise 30M the unprofitable firm can sell a fraction of its stake equal to the required amount d... View the full answer