Major Motors Company has an existing product that will produce future cash flows with a present value of $80M if demand for the product is high and $40M if demand for the product is low. There is a 50% probability that demand for the product is high and a 50% probability that demand for the product is low. Major Motors' management knows whether demand for the product is high or low, but outside investors only know that there is a 50% probability of each possibility and that management knows whether demand for the product is high or low. Major Motors can also launch a new product. Doing so requires investing $30M today and will generate future cash flow with a present value of $40M. Major Motors has no cash, so it will need to raise capital to finance the investment. Assume that it can only issue equity (i.e., debt financing is not possible). Apart from its existing product and potential new product, Major Motors has no other assets. Major Motors management acts to maximize current shareholder value.

 

a) Suppose that investors believe that Major Motors will only issue equity if management knows that demand for its existing product is low and prices the company's equity accordingly. Will Major Motors issue equity if demand for the existing product is high? Will Major Motors issue equity if demand for the existing product is low?

 

b) Suppose that Major Motors can hire a market research firm at a cost of $5M who can observe demand for the existing product and credibly report this information to investors. Will Major Motors hire the market research firm if demand for its existing product is high? Will Major Motors hire the market research firm if demand for its existing product is low?

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a If investors believe that Major Motors will only issue equity if management knows that demand for ... View the full answer