A firm has existing operations that generate an earnings stream with a present value, PV, of 300 or 600, each with 0.5 probability. The firm has 250 in existing debt. The firm wishes to undertake one of the following mutually exclusive new investments:

The capital cost of each project (400) is financed with new junior debt (face value 400). Is there an asset substitution problem? (Will shareholders try to choose the lower NPV project?) Show whether any asset substitution problem would disappear if the new project were financed with an equity issue of 400 instead of new debt.

Project A Project B Capital Cost 400 400 PV of Earnings 420 0; probability 0.5 NPV -20 -50 or 700; probability 0.5