(Asset Substitution/Risk-Shifting – the over-investment Problem)
Consider Baxter, Inc., which is facing financial distress.
 -Baxter has a loan of $1 million due at the end of the year.
 -Without a change in its strategy, the market value of its assets will be $900,000 at that time, and Baxter will default on its debt.
 -Baxter is considering a new strategy
 -The new strategy requires no upfront investment, but it has only a 50% probability of success.
 -If the new strategy succeeds, it will increase the value of the firm’s assets by $400,000 (i.e., to $1.3 million).
-If the new strategy fails, the value of the firm’s assets will fall by $600,000 (i.e., to $300,000).

(i) What is the NPV of the new strategy? Should the manager invest in the new strategy if her goal is to maximize firm value? (Note: the new strategy requires no investment, only affects future expected payoff). (assume 0% discount rate).

(ii) Calculate the values of the firm’s assets, debt, and equity (1) without a change to strategy and (2) with a change to strategy (assume 0% discount rate).
(1) Without a change to strategy:

Payoffs	Assets	Debt	Equity
	900	900	0
Value (Discounted Expected Payoff)	900	900	0

(2) With a change to strategy: (Calculate payoffs for Assets/Debt/Equity State-by-State!)

Payoffs	Assets	Debt	Equity
Good State (p=.5)
Bad State (P=.5)
Value (Discounted Expected Payoffs)

(iii) Will the manager invest in the new strategy if her goal is to maximize shareholders’ wealth? Explain.

Answer rating: 100% (QA)

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