Gator Software has just completed an R&D project that required borrowing $70 million in

senior debt from a bank. This R&D effort has resulted in an investment opportunity that will

cost an additional $100 million and will result in a cash flow of $90 million with probability

.5 and $210 million with probability .5. The firm has no cash on hand and no other assets

except for this investment opportunity. Assume risk-neutrality, a zero interest rate, no direct

bankruptcy costs, and no taxes.

Note: Unlike the first debt overhang exercise we did in class, the success of the project is not

known here at the time it is financed. In other words, at the time of the new security issue all

parties expect future cash flows to be $90 million with probability .5 and $210 million with

probability .5.

(a) Can the firm fund the investment opportunity with an equity issue?

(b) Can the firm fund the investment opportunity with an issue of junior debt?

(c) Can the firm fund the investment opportunity with a sale of senior debt to a new investor

with a promised repayment of $120? (Here, assume that this is allowed in the existing bank

loan agreement, and that the new debt will have the same seniority as the old debt in

bankruptcy).

(d) Can the firm fund the investment opportunity with an issue of new senior debt with a

promised repayment of greater than $120 (again assume that the new debt will have the same

seniority as the old one in case of bankruptcy). What would you predict for the minimum

face value (i.e., promised repayment) of the new debt that would be necessary to raise funds

for the investment opportunity?