Question: A firm can choose between two projects, Project A and B. The payoffs to each project depend on whether the world turns out to be

A firm can choose between two projects, Project A and B. The payoffs to each project depend on whether the world turns out to be in State 1 or State 2, each of which occurs with a 50% chance. The payoffs are given by:

	State 1	State 2
Project A Payoff	0	10
Project B Payoff	9	9

(a) Suppose that the face value of the firm's debt is zero, i.e., the firm has no debt. Which project will the equity holders choose? (b) For which face values of debt will equity holders choose Project A? (c) Suppose the face value of the debt is 8.5 in total. Also, suppose there are 100 bondholders, each owning face value worth 0.085. Consider the following exchange offer to bondholders. Shareholders offer junior bonds with a total face value of 5. The exchange offer is accepted if 50% of the bondholders agree to accept it. Any bondholder who does not accept keeps their senior bond with face value of 0.085. Suppose all other 99 bondholders exchange. Knowing this, will you exchange? (d) Given the individual bond holder's calculation done in part (c), will the exchange offer succeed when there are 100 bondholders? Why or why not? If not, what can be done to improve the chance of success of the offer? (e) If there was just one bondholder, would s/he accept the exchange offer? Why or why not?

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