Assume that investors are risk neutral, i.e., in the context of the CAPM model, Rm=rf. Consider the following investment problem. Currently, at date 0, ABC corporation's assets consist entirely of £1000 of cash. The risk- free rate, rf=0.05

 

At date 1, the shareholders of ABC are obligated to pay a bank £1000. Date 1 is the last date, After this date, the cash flows of ABC will be distributed to shareholders (as a dividend) and the bank (as debt payment). ABC has only one investment opportunity, the opportunity requires investing £1000 at date 0, and at date1, the investment will return £2000 with probability 0.25 and will return £0 with probability 0.75.

 

a. What is the NPV of this investment?

b. If shareholder make investment decisions with the aim of maximizing the wealth of shareholders, will ABC accept the investment project?

c. How will accepting this investment affect the value of the bank's loan?

d. Is accepting this project an example of risk shifting, underinvestment, both risk shifting and underinvestment, or neither risk shifting or underinvestment. Please briefly Explain your answer.

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a The net present value NPV of the investment can be calculated as the difference between the presen... View the full answer