Consider a firm that has debt obligations of $120 due next year and $60 due in the

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Question:

Consider a firm that has debt obligations of $120 due next year and $60 due in the following year. There are no taxes nor any interest payments. The firm is considering two mutually exclusive projects: i. A short-term project that generates $60 with certainty next year and 0 the year after, ii. A long-term project that generates $20 with certainty next year and $50 with certainty the year after. The firm also has assets in place that generate $60 with certainty next year and either $80 or $30 the following year with equal probabilities. If the firm chooses the short-term project, the Year 1 creditors get the entire Year 1 cash flow, and the firm survives to Year 2. If the firm chooses the long-term project, it is short of $40 to meet its Year 1 debt obligation. However, the manager can try to raise this money in the competitive financial market by issuing a new debt, which will be due in Year 2. The new creditors are junior with respect to the existing Year 2 creditors. If the manager does not manage to raise the lacking funds, then the firm is liquidated, the Year 1 creditors get the entire Year 1 cash flow, and all other agents get 0. Assume that the interest rate is zero and everybody is risk-neutral. The shareholders have limited liability.

a) If the manager chooses the long-term project, will he be able to raise the lacking amount in the market? What is the face value he will have to promise to new creditors? Explain your answer carefully and provide intuition where necessary.

b) Assume that the manager's goal is to maximize the total value of the firm. Which project will he choose? Explain your answer carefully and provide intuition where necessary.

c) Assume that the manager's goal is to maximize the firm's equity value. Which project will he choose? Compare your answer to part (b). Explain your answer carefully and provide intuition where necessary.

d) How would your answers to parts (a), (b) and (c) change if the firm's Year 1 debt obligation was $100 instead of $120? Explain your answer carefully and provide intuition where necessary