In a three-period economy, there is a group of risk-neutral investors and a firm that has...

 

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In a three-period economy, there is a group of risk-neutral investors and a firm that has an opportunity to take on a project. At t = -1, the firm's type, either High or Low, is revealed to the manager. Only the manager knows the firm's type but the investors do not. At 1 = 0, the firm's manager decides whether or not to take the project. At t = 1, the firm receives cash flows from the assets-in-place and the project. High-type firm has assets-in-place worth H=100, compared to L = 50 for a Low-type firm. Both types have an investment project which costs /= 20 to undertake, and yields a cash flow at the end of the period of V = 30. We assume that the firm's manager maximizes the wealth of the original shareholders, and the probability that the firm type is high is 10%. Assume the discount rate is 0%. (a) What is the NPV of the investment project? (2 marks) In part (b), let's assume the firm has $20 financial slack. (b) Would the manager of the High- and Low-type firm undertake this project? (2 marks) In part (c), let's assume the firm has no financial slack, and therefore must issue equity to obtain the $20 for investment. (c) Fill in the following payoff table. Show your workings on calculating the payoff to the High- and Low-type firm if they take / do not take the project. High-type Low-type Do not take the project (2 marks) (2 marks) Take the project (4 marks) (4 marks) (d) Based on your answer from part (c), would the manager undertake this project? Explain your answer. (4 marks) In a three-period economy, there is a group of risk-neutral investors and a firm that has an opportunity to take on a project. At t = -1, the firm's type, either High or Low, is revealed to the manager. Only the manager knows the firm's type but the investors do not. At 1 = 0, the firm's manager decides whether or not to take the project. At t = 1, the firm receives cash flows from the assets-in-place and the project. High-type firm has assets-in-place worth H=100, compared to L = 50 for a Low-type firm. Both types have an investment project which costs /= 20 to undertake, and yields a cash flow at the end of the period of V = 30. We assume that the firm's manager maximizes the wealth of the original shareholders, and the probability that the firm type is high is 10%. Assume the discount rate is 0%. (a) What is the NPV of the investment project? (2 marks) In part (b), let's assume the firm has $20 financial slack. (b) Would the manager of the High- and Low-type firm undertake this project? (2 marks) In part (c), let's assume the firm has no financial slack, and therefore must issue equity to obtain the $20 for investment. (c) Fill in the following payoff table. Show your workings on calculating the payoff to the High- and Low-type firm if they take / do not take the project. High-type Low-type Do not take the project (2 marks) (2 marks) Take the project (4 marks) (4 marks) (d) Based on your answer from part (c), would the manager undertake this project? Explain your answer. (4 marks)

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a NPV of the investment project Cash flows Project payoff 30 Project cost 20 10 Probability firm i... View the full answer