An all-equity firm has assets in place that have a true value of either $100 million (good
Question:
An all-equity firm has assets in place that have a true value of either $100 million (“good” state) or $60 million (“bad” state). The firm’s management knows the true value of the assets. However, the market does not know it and thinks that the low value and the high value are equally likely. The firm has a project that requires an investment of $30 million and yields a cash flow with a present value of $40 million. The market is perfectly aware of the existence of the project. The firm has no cash so it has to raise the money in the market. The project cannot be financed as a separate entity, so any securities that the firm issues are claims on the whole firm. The management acts in the interest of the current shareholders. Everybody is risk neutral. The capital market is competitive.
For parts (a)-(c) assume the only type of securities the firm can issue is equity.
a) What is a pooling equilibrium in this context? Does a pooling equilibrium exist in which the firm issues the same fraction of equity and implements the project both in the good state and the bad state? Explain your answer carefully and provide intuition where necessary.
b) What is a separating equilibrium in this context? Does a separating equilibrium exist in which the firm raises funds and implements the project only in the bad state? Explain your answer carefully and provide intuition where necessary.
c) Carefully discuss how each of the following would affect the manager’s incentives to issue equity in the good state: i. greater value of the assets in place in the bad state. ii. lower required investment for the project.
d) Now introduce the possibility of financing the project by issuing risk-free debt (assume that the firm’s cash flow is safe enough to never default regardless of the state). The firm is still allowed to issue equity. What will the firm issue depending on the state? Explain your answer carefully and provide intuition where necessary.
Managerial Economics Theory Applications and Cases
ISBN: 978-0393912777
8th edition
Authors: Bruce Allen, Keith Weigelt, Neil A. Doherty, Edwin Mansfield