Lemon Inc. has existing assets in place and the opportunity to invest $400 in a new project. Two possible outcomes are equally likely. In the good state of the world, the assets in place are worth $1500 and the new project has an NPV of $100. In the bad state of the world, the assets in place are worth $320 and the new project has an NPV of $80. The managers know which state will occur, but outside investors do not. The firm has no cash on hand to fund the project and it can only fund the project with equity. The managers have a large share block and have no plans to sell their holdings. Consequently, they want to maximize the “intrinsic” value of the shares held by the company’s current stockholders.

A. If the firm decides to issue equity, can the outside investor infer which state of the world is the true state (is there a separating equilibrium)? Provide an explanation of your answer (with numerical support).

B. Now assume everything is the same, except that the assets in place of the good firm are lower than $1600, but larger than $320. If the value of assets in place for the good firm is low enough, there is no separating equilibrium because the good firm will choose to deviate and issue equity, even if investors believe that only bad firms issue equity. What is this value of assets in place for the good firm that is low enough so that there is no separating equilibrium?

Answer rating: 100% (QA)

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