You are the manager of a financially distressed corporation with $1.5 million in debt outstanding that will mature in three months. Your firm currently has $1 million cash on hand. Assume that you are offered the opportunity to invest in either of the two projects described below.
Project 1: the opportunity to invest $1 million in risk-free Treasury bills, with a 4 percent annual interest rate (a quarterly interest rate of 1 percent = 4% per year ÷ 4 quarters per year)
Project 2: a high-risk gamble, which will pay off $1.6 million in two months if successful (probability = 0.4), but will only pay $400,000 if unsuccessful (probability = 0.6)
a. Compute the expected payoff for each project, and state which one you would adopt if you were operating the firm in the shareholders’ best interests? Why?
b. Which project would you accept if the firm was unlevered? Why?
c. Which project would you accept if the company was organized as a partnership rather than a corporation? Why?