Consider a levered firm that is considering two mutually exclusive projects: project A and project B. The promised payoff to the bond holders is 200:

project A

profitability Value of firm

0.50 200

0.50. 400

Project B

profitability Value of firm

0.50 100

0.50 480

a) calculate the expected payoff to the bond holders, and the expected payoff to the shareholders for both A and B.

b) which project would be the shareholder choose if the firm were all equity financed?

c) given the current levered state, which project would the shareholders choose?

d) name the two problems that arise from the conflicts of interest between shareholders and bond holders. These two problems worsen during financial distress.