A firm is considering a new project that would require an investment of $11 million today, and would result in a certain cash flow of $14 million in one year.

Cash flows from the firms existing projects next year are expected to be $60 million if the economy is in a good state and $20 million if it is bad. The probability of the good state is 70%.

The firm has existing debt with face value $45 million due in one year. To finance the new project it can issue new debt which will have a lower priority for payment in the event of bankruptcy.

Assume that investors are risk neutral and the appropriate discount rate is zero.

(a) What are the values of the firms equity and debt without the new project? If the new project is undertaken, what will be the value of the firms original debt?

(b) What payoff will the new lenders require in the good state of the economy?

(c) What will be the value of the firms equity with the new project?

(d) Explain what is meant by debt overhang and briefly suggest how this problem might be reduced. Illustrate your answer with reference to your results in the previous parts of the question