Consider a firm that currently has debt with face value of $1,000 that will come due in one year and assets that are projected to be worth $900 in one year.

Suppose the firm has an opportunity to invest in a new project requiring an immediate investment of $100, offering an IRR of 50% in one year.

Suppose the only way to get the $100 for the initial investment is for the existing equity holders to contribute it.

(i) Assume that the required rate of return for this project is less than 50%. Should the manager invest in the project if her goal is to maximize firm value? (Think: expected rate of return vs required rate of return, and what it says about the projects NPV).

(ii) Calculate the value of the firm, the debt and equity (1) without the new project and (2) with the new project (assume 0% discount rate).

	Existing Assets	DEBT	EQUITY
PAYOFF
VALUE (DISCOUNTED EXPECTED PAYOFF)

	Existing Assets	NEW PROJECT	TOTAL ASSETS	DEBT	EQUITY
PAYOFF
VALUE (DISCOUNTED EXPECTED PAYOFF)